Final Regs Provide Rules on Election and Termination of Subchapter Status

 [4830-01]

 ACTION: Final and temporary regulations.

 SUMMARY: This document contains final regulations that relate to small business corporations and the election, revocation, termination, and corporate effect of electing subchapter S treatment as a result of the changes to the tax law made by the Subchapter S Revision Act of 1982, the Reform Act of 1984, the Tax Reform Act of 1986, and the Technical and Miscellaneous Revenue Act of 1988. The regulations affect S corporations and their shareholders and are necessary to provide them with the guidance they need to comply with the applicable tax law.

 DATES: These regulations are effective November 25, 1992, and apply to taxable years beginning after December 31, 1992.

 FOR FURTHER INFORMATION CONTACT: Andrea Tucker, (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collections of information requirement contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1308. The estimated annual burden per respondent varies depending on individual circumstances with an estimated average of 3 hours and 18 minutes for those taxpayers filing Form 1040X. For all other collections of information in this regulation, the estimated average time is 30 minutes.

 These estimates approximate the average time needed to collect the information and are based on such information as is available to the Internal Revenue Service. Individual respondents may require more or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington D.C. 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

 This document amends the Income Tax Regulations (26 CFR Part 1) under sections 1362 and 1363 of the Internal Revenue Code of 1986, as amended (Code). These amendments are necessary to implement sections 1362 and 1363 as added by section 2 of the Subchapter S Revision Act of 1982 and as amended by sections 102 and 721 of the Tax Reform Act of 1984, sections 511, 632, and 701 of the Tax Reform Act of 1986, and sections 1006(f)(6)-(7) and 1007(g)(9) of the Technical and Miscellaneous Revenue Act of 1988.

 On January 26, 1983, temporary regulations (TD 7872) relating to the election and termination of subchapter S status were published in the Federal Register. Amendments to the temporary regulations were published in the Federal Register on September 10, 1984 (TD 7976) and October 1, 1984 (TD 7979). A notice of proposed rulemaking concerning the election, termination, and corporate effect of subchapter S status was published on December 27, 1988 (53 FR 52190) (the proposed regulations). Written comments were received. In response to some of the comments received, a second notice of proposed rulemaking was published on April 17, 1992 (57 FR 13676), that replaced portions of the earlier proposed regulations (the reproposed regulations). Again, written comments were received. After consideration of the comments, the proposed regulations, as amended, are adopted as revised by this Treasury decision, and the corresponding temporary regulations are removed.

EXPLANATION OF PROVISIONS

 Except for modifications in response to comments, these final regulations generally provide the same rules as the proposed regulations, as amended by the reproposed regulations. Thus, the regulations provide rules under section 1362 regarding the election of S corporation status, and the termination of an S corporation election, including inadvertent terminations and the re-election of S status. The regulations also include rules under section 1363, regarding the effect of an S election.

 However, the final regulations are simplified and shortened so they are easier to apply. In some cases the regulations have been restructured in order to accomplish these goals. For example, to facilitate applying the regulations, the rules concerning the manner of making elections, including who must consent to elections, appear in one section and are generally uniform for all elections under section 1362. In addition, in order to simplify the regulations, the final regulations do not reiterate statutory language that is clear on its face. For example, the statutory language of section 1362(e)(5) concerning the annualization of income during a C short taxable year is self-explanatory and does not need to be repeated in the regulations. Unless otherwise noted, these revisions are not intended to make substantive changes from the proposed regulations.

I. ELECTION TO BE AN S CORPORATION

 The final regulations describe how a small business corporation elects S corporation status and when the election is effective. In response to comments, the final regulations clarify the following points concerning the timing and validity of S elections: (1) an S election is valid only if the electing corporation qualifies as a small business corporation on the date of the election and on each day of the taxable year for which the election is effective; (2) an S election is not invalid because a corporation fails to qualify as a small business corporation after the date of the election and before the first day of the taxable year for which the election is effective; and (3) an S election made during the first 2-1/2 months of a corporation's taxable year can be made effective for the following taxable year.

 In addition, in response to comments, the final regulations clarify who must consent to the election. For example, under the final regulations, in addition to executors or administrators, other fiduciaries appointed by testamentary instrument or by court order may consent to elections on behalf of estates.

II. TERMINATION OF AN ELECTION

 An S election may be terminated in one of three ways. First, the electing corporation may revoke its S election. The regulations explain how a revocation is made and how it may be rescinded. Second, if the electing corporation ceases to be a small business corporation, its S election terminates. Third, if for three consecutive taxable years an electing corporation has C corporation earnings and profits and has passive investment income in excess of 25 percent of gross receipts, the corporation's S election terminates.

A. TERMINATION DUE TO EXCESS PASSIVE INVESTMENT INCOME

1. GROSS RECEIPTS

The regulations define the term "gross receipts" for purposes of the termination rules. In general, gross receipts include any amount realized by the corporation. Section 1362(d)(3) provides special rules for including amounts realized from dispositions of capital assets, stock, or securities in gross receipts and passive investment income. Under these rules, gains from sales or exchanges of stock or securities are included in gross receipts and in passive investment income on a gross basis.

 The regulations define what constitutes stock or securities for purposes of these rules. Under the proposed regulations, any interest in a partnership is treated as a security. Thus, any gain on sale or other disposition of a partnership interest is included in both gross receipts and passive investment income. A number of comments suggest that this rule is not appropriate because it treats S corporations more harshly if they conduct a business through a partnership by causing all of the gain on the disposition of the partnership interest to be passive investment income. In contrast, if an S corporation that conducts a business directly disposes of its business, only gain realized on the sale of any stock or securities is passive investment income. The comments also point out that certain partnership interests, for example, general partner interests, are not considered securities for other tax purposes. Comments suggest that the final regulations adopt some type of look- through rule for partnership interests held by S corporations. For example, under a look-through rule, gain on the disposition of the corporation's partnership interest would be treated as gain on the sale or exchange of stock or securities to the extent the corporation would have had gain if the partnership had sold its stock or securities. In the case of tiered partnerships, the look-through rule would be applied at each tier.

 In response to these comments, the final regulations generally treat only an interest as a limited partner in a partnership as a security. The Service and Treasury believe that a limited partner interest is sufficiently passive that it is appropriately treated as a security for purposes of section 1362(d)(3). The final regulations generally adopt the look-through approach for interests as a general partner as suggested in the comments. In addition, because applying the look-through approach may be burdensome for some S corporations, the final regulations provide that an S corporation may choose to treat a general partner interest as a security.

2. PASSIVE INVESTMENT INCOME

Passive investment income as defined under the final regulations generally includes gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities. The reproposed regulations provide broad exceptions from the definition of passive investment income. The exceptions generally exclude income derived by an S corporation in the ordinary course of a trade or business from the definition of passive investment income.

 In response to the reproposed regulations, commentators suggest additional exceptions. The comments suggest a rule for rents that would exclude from passive investment income amounts received in the ordinary course of a trade or business of renting property.

 The comments also suggest incorporating the personal holding company exception for rental income derived from leasing self- produced personal property (see section 543(b)(3)(D)). Additionally, the comments suggest extending this exception to income derived from leasing self-developed real property.

 The Service and Treasury believe that these exceptions are consistent with the purpose of the reproposed regulations to distinguish income earned in the ordinary course of a trade or business from passive investment income. Accordingly, these suggestions have been adopted. In the case of rental income earned in an active trade or business, however, these amounts are excluded from passive investment income only if the corporation performs significant services or incurs substantial costs in the rental business as determined under all the facts and circumstances.

 Also, in response to comments, the final regulations clarify that securities brokers and dealers are dealers in property for purposes of applying the passive investment income rules. See EXAMPLE 6 of section 1.1362-2(c)(6).

III. TREATMENT OF S TERMINATION YEAR

 If a corporation's election terminates for any reason on a day other than the first day of a taxable year of a corporation, the taxable year in which the termination occurs is an S termination year. An S termination year is divided into a short S corporation year that ends on the day before the date of termination and a short C corporation year that begins as of the date that the termination is effective.

 Ordinarily, each item of the corporation for the S termination year is allocated on a pro rata basis to each day of the S termination year. However, a corporation is required to close its books as of the termination date if either (1) the corporation and all of its shareholders consent; (2) a purchase of stock is treated as an asset purchase under section 338 (to the extent of items resulting from the application of section 338); or (3) there is a 50 percent change in ownership of the corporation during the S termination year. The regulations provide guidance on each of these exceptions to the pro rata allocation rule.

 The proposed regulations provide a special rule for partnership interests held by a corporation during the S short year portion of an S termination year. Under the special rule, the corporation is treated for purposes of section 706(c) as if it sold or exchanged the entire partnership interest on the last day of the S short year. This special rule only applies if the corporation does not use the pro rata allocation rule, and if any taxable year of the partnership ends with or within the C short year portion of the S termination year. Thus, the effect of the special rule is to include partnership items for the period of the partnership's taxable year ending as of the sale or exchange in the S short year.

 One comment requests that this rule be deleted from the final regulations. Other comments request that the final regulations expressly provide that the corporation is not treated as if it sold or exchanged the partnership interest for purposes of other partnership provisions, including section 708(b) (relating to deemed terminations of partnerships) and section 754 (relating to elective basis adjustments).

 The final regulations retain the special rule for an S corporation that is a partner in a partnership in order to properly apportion partnership items in the S termination year. However, the final regulations clarify that the rule applies for purposes of section 706(c) only.

 The Service also received comments regarding the application of the pro rata allocation rule to items arising directly from the conversion of the corporation to a C corporation. Comments suggest that certain items relating to the short C year should not be in any part allocable to the short S year even if the pro rata rule applies. The Code, however, provides two methods for allocating income during the S termination year. Taxpayers may allocate under the pro rata method or may close the books (by election with the consent of all shareholders). Taxpayers thus may elect to close the books rather than have the pro rata method apply if items recognized relating to the short C year should be allocable only to that year. In light of the availability of the close the books method, and because the Code does not specify special treatment of certain items, the final regulations do not implement any special rules.

IV. EFFECTIVE DATES

 The final regulations are effective for taxable years of corporations beginning after December 31, 1992. Except as discussed below with regard to the definition of passive investment income, for taxable years to which the final regulations do not apply, S corporations and their shareholders must take reasonable return positions taking into account the statute, the legislative history, the previously published temporary regulations, the final regulations, and the proposed regulations pursuant to Notice 92-56, published in the Internal Revenue Bulletin.

 Special effective date rules under section 1.1362-7(b) are provided for application of the definition of passive investment income to prior taxable years. Under these rules, an S corporation and its shareholders may apply section 1.1362-2(c)(5) (regarding the definition of passive investment income) to a prior taxable year only if the year is not closed and the former proposed regulations could be applied, if effective as proposed, to that year. The reproposed regulations were proposed to be effective for taxable years beginning after December 31, 1981; accordingly, section 1.1362-2(c)(5) of these regulations can be applied to taxable years beginning after December 31, 1981. In addition, section 1.1362-2(c)(5)(iii)(A) (relating to special rules for options and commodities dealers) can be applied only after the effective date of the 1984 statutory amendment on which the provision is based. Thus, section 1.1362-2(c)(5)(iii)(A) can be applied to positions in options and commodities established after July 18, 1984, in taxable years ending after that date.

 An election to apply section 1.1362-2(c)(5) retroactively is made by filing returns (original or amended, including claims for refunds) consistent with the provisions of the regulations. To effectuate the application of these rules to prior years, the Service will permit S corporations and their shareholders to revoke an election made under section 1368(e)(3) or under former section 1.1375-4(c) (relating to the election to by-pass previously taxed income). The S corporation and all affected shareholders must file returns that are consistent with section 1.1362-2(c)(5) to make this election. In response to comments, the final regulations clarify that the term AFFECTED SHAREHOLDERS means all shareholders who received distributive shares of S corporation items for the taxable year for which the election is made and all subsequent shareholders.

 If an S corporation and its shareholders wish to apply section 1.1362-2(c)(5) for a prior open taxable year, but cannot file all of the necessary returns for that prior year and/or subsequent years, the regulations provide that, in appropriate circumstances, the Commissioner may permit the application of these rules to prior years even if all affected shareholders cannot file consistent returns. Comments suggest specifying the situations in which this relief would be available. The Service recognizes that there could be certain cases where relief would ordinarily be granted. However, the Service and the Treasury believe that the granting of relief must be based on the facts and circumstances of each case, so no specific situations are described in the final regulations.

SPECIAL ANALYSIS

 These final regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Regulatory Flexibility Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these proposed regulations is Andrea Tucker of the Office of Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the Internal Revenue Service and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR 1.1361-OA through 1.1378-3

 Income taxes, Reporting and recordkeeping requirements, Small businesses.

Treasury Decision 8449

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR, parts 1, 18 and 602 are amended as follows:

Part 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by adding the following citation:

Authority: 26 U.S.C. 7805 * * * Sections 1.1362-1, 1.1362-2, 1.1362-3, 1.1362-4, 1.1362-5, 1.1362-6, 1.1362-7, and 1.1363-1 also issued under 26 U.S.C. 1377.

Par. 2. Sections 1.1362-0 through 1.1362-7 and 1.1363-1 are added to read as follows:

SECTION 1.1362-0 TABLE OF CONTENTS.

This section lists the captions that appear in the regulations under section 1362.

 SECTION 1.1362-1 ELECTION TO BE AN S CORPORATION.

(a) IN GENERAL. Except as provided in section 1.1362-5, a small business corporation as defined in section 1361 may elect to be an S corporation under section 1362(a). An election may be made only with the consent of all of the shareholders of the corporation at the time of the election. See section 1.1362-6(a) for rules concerning the time and manner of making this election.

(b) YEARS FOR WHICH ELECTION IS EFFECTIVE. An election under section 1362(a) is effective for the entire taxable year of the corporation for which it is made and for all succeeding taxable years of the corporation, until the election is terminated.

SECTION 1.1362-2 TERMINATION OF ELECTION.

(a) TERMINATION BY REVOCATION -- (1) IN GENERAL. An election made under section 1362(a) is terminated if the corporation revokes the election for any taxable year of the corporation for which the election is effective, including the first taxable year. A revocation may be made only with the consent of shareholders who, at the time the revocation is made, hold more than one-half of the number of issued and outstanding shares of stock (including non-voting stock) of the corporation. See section 1.1362-6(a) for rules concerning the time and manner of revoking an election made under section 1362(a).

(2) WHEN EFFECTIVE -- (i) IN GENERAL. Except as provided in paragraph (a)(2)(ii) of this section, a revocation made during the taxable year and before the 16th day of the third month of the taxable year is effective on the first day of the taxable year and a revocation made after the 15th day of the third month of the taxable year is effective for the following taxable year. If a corporation makes an election to be an S corporation that is to be effective beginning with the next taxable year and revokes its election on or before the first day of the next taxable year, the corporation is deemed to have revoked its election on the first day of the next taxable year.

(ii) REVOCATIONS SPECIFYING A PROSPECTIVE REVOCATION DATE. If a corporation specifies a date for revocation and the date is expressed in terms of a stated day, month, and year that is on or after the date the revocation is filed, the revocation is effective on and after the date so specified.

(3) EFFECT ON TAXABLE YEAR OF CORPORATION. In the case of a corporation that revokes its election to be an S corporation effective on the first day of the first taxable year for which its election is to be effective, any statement made with the election regarding a change in the corporation's taxable year has no effect.

(4) RESCISSION OF A REVOCATION. A corporation may rescind a revocation made under paragraph (a)(2) of this section at any time before the revocation becomes effective. A rescission may be made only with the consent of each person who consented to the revocation and by each person who became a shareholder of the corporation within the period beginning on the first day after the date the revocation was made and ending on the date on which the rescission is made. See section 1.1362-6(a) for rules concerning the time and manner of rescinding a revocation.

(b) TERMINATION BY REASON OF CORPORATION CEASING TO BE A SMALL BUSINESS CORPORATION -- (1) IN GENERAL. If a corporation ceases to be a small business corporation, as defined in section 1361(b), at any time on or after the first day of the first taxable year for which its election under section 1362(a) is effective, the election terminates. In the event of a termination under this paragraph (b)(1), the corporation should attach to its return for the taxable year in which the termination occurs a notification that a termination has occurred and the date of the termination.

(2) WHEN EFFECTIVE. If an election terminates because of a specific event that causes the corporation to fail to meet the definition of a small business corporation, the termination is effective as of the date on which the event occurs. If a corporation makes an election to be an S corporation that is effective beginning with the following taxable year and is not a small business corporation on the first day of that following taxable year, the election is treated as having terminated on that first day. If a corporation is a small business corporation on the first day of the taxable year for which its election is effective, its election does not terminate even if the corporation was not a small business corporation during all or part of the period beginning after the date the election was made and ending before the first day of the taxable year for which the election is effective.

(3) EFFECT ON TAXABLE YEAR OF CORPORATION. In the case of a corporation that fails to meet the definition of a small business corporation on the first day of the first taxable year for which its election to be an S corporation is to be effective, any statement made with the election regarding a change in the corporation's taxable year has no effect.

(c) TERMINATION BY REASON OF EXCESS PASSIVE INVESTMENT INCOME -- (1) IN GENERAL. A corporation's election under section 1362(a) terminates if the corporation has subchapter C earnings and profits at the close of each of three consecutive taxable years and, for each of those taxable years, has passive investment income in excess of 25 percent of gross receipts. See section 1375 for the tax imposed on excess passive investment income.

(2) WHEN EFFECTIVE. A termination under this paragraph (c) is effective on the first day of the first taxable year beginning after the third consecutive year in which the S corporation had excess passive investment income.

(3) SUBCHAPTER C EARNINGS AND PROFITS. For purposes of this paragraph (c), SUBCHAPTER C EARNINGS AND PROFITS of a corporation are the earnings and profits of any corporation, including the S corporation or an acquired or predecessor corporation, for any period with respect to which an election under section 1362(a) (or under section 1372 of prior law) was not in effect. The subchapter C earnings and profits of an S corporation are modified as required by section 1371(c).

(4) GROSS RECEIPTS -- (i) IN GENERAL. For purposes of this paragraph (c), GROSS RECEIPTS generally means the total amount received or accrued under the method of accounting used by the corporation in computing its taxable income and is not reduced by returns and allowances, cost of goods sold, or deductions.

(ii) SPECIAL RULES FOR SALES OF CAPITAL ASSETS, STOCK AND SECURITIES -- (A) SALES OF CAPITAL ASSETS. For purposes of this paragraph (c), gross receipts from the sales or exchanges of capital assets (as defined in section 1221), other than stock and securities, are taken into account only to the extent of capital gain net income (as defined in section 1222).

(B) SALES OF STOCK OR SECURITIES -- (1) IN GENERAL. For purposes of this paragraph (c), gross receipts from the sales or exchanges of stock or securities are taken into account only to the extent of gains therefrom. In addition, for purposes of computing gross receipts from sales or exchanges of stock or securities, losses do not offset gains.

(2) TREATMENT OF CERTAIN LIQUIDATIONS. Gross receipts from the sales or exchanges of stock or securities do not include amounts described in section 1362(d)(3)(D)(iv), relating to the treatment of certain liquidations. For purposes of section 1362(d)(3)(D)(iv), stock of the liquidating corporation owned by an S corporation shareholder is not treated as owned by the S corporation.

(3) DEFINITION OF STOCK OR SECURITIES. For purposes of this paragraph (c), STOCK OR SECURITIES includes shares or certificates of stock, stock rights or warrants, or an interest in any corporation (including any joint stock company, insurance company, association, or other organization classified as a corporation under section 7701); an interest as a limited partner in a partnership; certificates of interest or participation in any profit-sharing agreement, or in any oil, gas, or other mineral property, or lease; collateral trust certificates; voting trust certificates; bonds; debentures; certificates of indebtedness; notes; car trust certificates; bills of exchange; or obligations issued by or on behalf of a State, Territory, or political subdivision thereof.

(4) GENERAL PARTNER INTERESTS -- (i) IN GENERAL. Except as provided in paragraph (c)(4)(ii)(B)(4)(ii) of this section, if an S corporation disposes of a general partner interest, the gain on the disposition is treated as gain from the sale of stock or securities to the extent of the amount the S corporation would have received as a distributive share of gain from the sale of stock or securities held by the partnership if all of the stock and securities held by the partnership had been sold by the partnership at fair market value at the time the S corporation disposes of the general partner interest. In applying this rule, the S corporation's distributive share of gain from the sale of stock or securities held by the partnership is not reduced to reflect any loss that would be recognized from the sale of stock or securities held by the partnership. In the case of tiered partnerships, the rules of this section apply by looking through each tier.

(ii) EXCEPTION. An S corporation that disposes of a general partner interest may treat the disposition, for purposes of this paragraph (c), in the same manner as the disposition of an interest as a limited partner.

(iii) OTHER EXCLUSIONS FROM GROSS RECEIPTS. For purposes of this paragraph (c), gross receipts do not include --

(A) Amounts received in nontaxable sales or exchanges except to the extent that gain is recognized by the corporation on the sale or exchange; or

(B) Amounts received as a loan, as a repayment of a loan, as a contribution to capital, or on the issuance by the corporation of its own stock.

(5) PASSIVE INVESTMENT INCOME -- (i) IN GENERAL. In general, PASSIVE INVESTMENT INCOME means gross receipts (as defined in paragraph (c)(4) of this section) derived from royalties, rents, dividends, interest, annuities, and gains from the sales or exchanges of stock or securities.

(ii) DEFINITIONS. For purposes of this paragraph (c)(5), the following definitions apply:

(A) ROYALTIES -- (1) IN GENERAL. ROYALTIES means all royalties, including mineral, oil, and gas royalties, and amounts received for the privilege of using patents, copyrights, secret processes and formulas, good will, trademarks, tradebrands, franchises, and other like property. The gross amount of royalties is not reduced by any part of the cost of the rights under which the royalties are received or by any amount allowable as a deduction in computing taxable income.

(2) ROYALTIES DERIVED IN THE ORDINARY COURSE OF A TRADE OR BUSINESS. ROYALTIES does not include royalties derived in the ordinary course of a trade or business of franchising or licensing property. Royalties received by a corporation are derived in the ordinary course of a trade or business of franchising or licensing property only if, based on all the facts and circumstances, the corporation --

(i) Created the property; or

(ii) Performed significant services or incurred substantial costs with respect to the development or marketing of the property.

(3) COPYRIGHT, MINERAL, OIL AND GAS, AND ACTIVE BUSINESS COMPUTER SOFTWARE ROYALTIES. ROYALTIES does not include copyright royalties, nor mineral, oil and gas royalties if the income from those royalties would not be treated as personal holding company income under sections 543(a)(3) and (a)(4) if the corporation were a C corporation; amounts received upon disposal of timber, coal, or domestic iron ore with respect to which the special rules of sections 631(b) and (c) apply; and active business computer software royalties as defined under section 543(d) (without regard to paragraph (d)(5) of section 543).

(B) RENTS -- (1) IN GENERAL. RENTS means amounts received for the use of, or right to use, property (whether real or personal) of the corporation.

(2) RENTS DERIVED IN THE ACTIVE TRADE OR BUSINESS OF RENTING PROPERTY. RENTS does not include rents derived in the active trade or business of renting property. Rents received by a corporation are derived in an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Generally, significant services are not rendered and substantial costs are not incurred in connection with net leases. Whether significant services are performed or substantial costs are incurred in the rental business is determined based upon all the facts and circumstances including, but not limited to, the number of persons employed to provide the services end the types and amounts of costs end expenses incurred (other then depreciation).

(3) PRODUCED FILM RENTS. RENTS does not include produced film rents as defined under section 543(a)(5).

(4) INCOME FROM LEASING SELF-PRODUCED TANGIBLE PROPERTY. RENTS does not include compensation, however designated, for the use of, or right to use, any real or tangible personal property developed, manufactured, or produced by the taxpayer, if during the taxable year the taxpayer is engaged in substantial development, manufacturing, or production of real or tangible personal property of the same type.

(C) DIVIDENDS. DIVIDENDS includes dividends as defined in section 316, amounts to be included in gross income under section 551 (relating to foreign personal holding company income taxed to U.S. shareholders), and consent dividends as provided in section 565. See paragraphs (c)(5)(iii)(B) and (C) of this section for special rules for the treatment of certain dividends and certain payments to a patron of a cooperative.

(D) INTEREST -- (1) IN GENERAL. INTEREST means any amount received for the use of money (including tax-exempt interest and amounts treated as interest under section 483, 1272, 1274, or 7872). See paragraph (c)(5)(iii)(B) of this section for a special rule for the treatment of interest derived in certain businesses.

(2) INTEREST ON OBLIGATIONS ACQUIRED IN THE ORDINARY COURSE OF A TRADE OR BUSINESS. INTEREST does not include interest on any obligation acquired from the sale of property described in section 1221(1) or the performance of services in the ordinary course of a trade or business of selling the property or performing the services.

(E) ANNUITIES. ANNUITIES means the entire amount received as an annuity under an annuity, endowment, or life insurance contract, if any part of the amount would be includible in gross income under section 72.

(F) GROSS RECEIPTS FROM THE SALE OF STOCK OR SECURITIES. Gross receipts from the sales or exchanges of stock or securities, as described in paragraph (c)(4)(ii)(B) of this section, are passive investment income to the extent of gains therefrom. See paragraph (c)(5)(iii)(B) of this section for a special rule for the treatment of gains derived in certain businesses.

(G) IDENTIFIED INCOME. PASSIVE INVESTMENT INCOME does not include income identified by the Commissioner by regulations, revenue ruling, or revenue procedure as income derived in the ordinary course of a trade or business for purposes of this section.

(iii) SPECIAL RULES. For purposes of this paragraph (c)(5), the following special rules apply:

(A) OPTIONS OR COMMODITIES DEALERS. In the case of an options dealer or commodities dealer, PASSIVE INVESTMENT INCOME does not include any gain or loss (in the normal course of the taxpayer's activity of dealing in or trading section 1256 contracts) from any section 1256 contract or property related to the contract. OPTIONS DEALER, COMMODITIES DEALER, and SECTION 1256 CONTRACT have the same meaning as in section 1362(d)(3)(E)(ii).

(B) TREATMENT OF CERTAIN LENDING, FINANCING AND OTHER BUSINESSES -- (1) IN GENERAL. PASSIVE INVESTMENT INCOME does not include gross receipts that are directly derived in the ordinary course of a trade or business of --

(i) Lending or financing;

(ii) Dealing in property;

(iii) Purchasing or discounting accounts receivable, notes, or installment obligations; or

(iv) Servicing mortgages.

(2) DIRECTLY DERIVED. For purposes of this paragraph (c)(5)(iii)(B), gross receipts directly derived in the ordinary course of business includes gain (as well as interest income) with respect to loans originated in a lending business, or interest income (as well as gain) from debt obligations of a dealer in such obligations. However, interest earned from the investment of idle funds in short-term securities does not constitute gross receipts directly derived in the ordinary course of business. Similarly, a dealer's income or gain from an item of property is not directly derived in the ordinary course of its trade or business if the dealer held the property for investment at any time before the income or gain is recognized.

(C) PAYMENT TO A PATRON OF A COOPERATIVE. PASSIVE INVESTMENT INCOME does not include amounts included in the gross income of a patron of a cooperative (within the meaning of section 1381(a), without regard to paragraph (2)(A) or (C) of section 1381(a)) by reason of any payment or allocation to the patron based on patronage occurring in the case of a trade or business of the patron.

(6) EXAMPLES. The principles of paragraphs (c)(4) and (c)(5) of this section are illustrated by the following examples. Unless otherwise provided in an example, S is an S corporation with subchapter C earnings and profits, and S's gross receipts from operations are gross receipts not derived from royalties, rents, dividends, interest, annuities, or gains from the sales or exchanges of stock or securities. S is a calendar year taxpayer and its first taxable year as an S corporation is 1993.

EXAMPLE 1. SALES OF CAPITAL ASSETS, STOCK AND SECURITIES. (i) S uses an accrual method of accounting end sells:

(1) a depreciable asset, held for more than 6 months, which is used in the corporation's business;

(2) a capital asset (other than stock or securities) for a gain;

(3) a capital asset (other than stock or securities) for a loss; and

(4) securities.

S receives payment for each asset partly in money and partly in the form of a note payable at a future time, and elects not to report the sales on the installment method.

(ii) The amount of money and the face amount (or issue price if different) of the note received for the business asset are considered gross receipts in the taxable year of sale and are not reduced by the adjusted basis of the property, costs of sale, or any other amount. With respect to the sales of the capital assets, gross receipts include the cash down payment and face amount (or issue price if different) of any notes, but only to the extent of S's capital gain net income. In the case of the sale of the securities, gross receipts include the cash down payment and face amount (or issue price if different) of the notes, but only to the extent of gain on the sale. In determining gross receipts from sales of securities, losses are not netted against gains.

EXAMPLE 2. LONG-TERM CONTRACT REPORTED ON PERCENTAGE-OF- COMPLETION METHOD. S has a long-term contract as defined in section 1.451-3(b) with respect to which it reports income according to the percentage-of-completion method as described in section 1.451-3(c)(1). The portion of the gross contract price which corresponds to the percentage of the entire contract which has been completed during the taxable year is included in S's gross receipts for the year.

EXAMPLE 3. INCOME REPORTED ON INSTALLMENT SALE METHOD. For its 1993 taxable year, S sells personal property on the installment plan and elects to report its taxable income from the sale of the property (other than property qualifying as a capital asset or stock or securities) on the installment method in accordance with section 453. The installment payment actually received in a given taxable year of S is included in gross receipts for the year.

EXAMPLE 4. PARTNERSHIP INTERESTS. In 1993, S and two of its shareholders contribute cash to form a general partnership, PRS. S receives a 50 percent interest in the capital and profits of PRS. S formed PRS to indirectly invest in marketable stocks and securities. The only assets of PRS are the stock and securities, and certain real and tangible personal property. In 1994, S needs cash in its business and sells its partnership interest at a gain rather than having PRS sell the marketable stock or securities that have appreciated. Under paragraph (c)(4)(ii)(B)(4) of this section, the gain on S's disposition of its interest in PRS is treated as gain from the sale or exchange of stock or securities to the extent of the amount the distributive share of gain S would have received from the sale of stock or securities held by PRS if PRS sold all of its stock or securities at fair market value at the time S disposed of its interest in PRS.

EXAMPLE 5. ROYALTIES DERIVED IN ORDINARY COURSE OF TRADE OR BUSINESS. (i) In 1993, S has gross receipts of $75,000. Of this amount, $5,000 is from royalty payments with respect to Trademark A, $8,000 is from royalty payments with respect to Trademark B, and $62,000 is gross receipts from operations. S created Trademark A, but S did not create Trademark B or perform significant services or incur substantial costs with respect to the development or marketing of Trademark B.

(ii) Because S created Trademark A, the royalty payments with respect to Trademark A are derived in the ordinary course of S's business and are not included within the definition of ROYALTIES for purposes of determining S's passive investment income. However, the royalty payments with respect to Trademark B are included within the definition of ROYALTIES for purposes of determining S's passive investment income. See paragraph (c)(5)(ii)(A) of this section. S's passive investment income for the year is $8,000, and S's passive investment income percentage for the taxable year is 10.67% ($8,000/$75,000). This does not exceed 25 percent of S's gross receipts and consequently the three-year period described in section 1362(d)(3) does not begin to run.

EXAMPLE 6. DIVIDENDS; GAIN ON SALE OF STOCK DERIVED IN THE ORDINARY COURSE OF TRADE OR BUSINESS. (i) In 1993, S receives dividends of $10,000 on stock of corporations P and O, recognizes a gain of $25,000 on sale of the P stock, and recognizes a loss of $12,000 on sale of the O stock. S held the P and O stock for investment, rather than for sale in the ordinary course of a trade or business. S has gross receipts from operations and from gain on the sale of stock in the ordinary course of its trade or business of $110,000.

(ii) S's gross receipts are calculated as follows:

 $110,000  Gross receipts from operations and from gain on

 $ 10,000  Gross dividend receipts

EXAMPLE 7. INTEREST ON ACCOUNTS RECEIVABLE; NETTING OF GAIN ON SALE OF REAL PROPERTY INVESTMENTS. (i) In 1993, S receives $6,000 of interest on accounts receivable arising from S's sales of inventory property. S also receives dividends with respect to stock held for investment of $1,500. In addition, S sells two parcels of real property (Property J and Property K) that S had purchased and held for investment. S sells Property J, in which S has a basis of $5,000, for $10,000 (a gain of $5,000). S sells Property K, in which S has a basis of $12,000, for $9,000 (a loss of $3,000). S has gross receipts from operations of $90,000.

(ii) S's gross receipts are calculated as follows:

 $ 90,000  Gross receipts from operations

EXAMPLE 8. INTEREST RECEIVED IN THE ORDINARY COURSE OF A LENDING BUSINESS. (i) In 1993, S has gross receipts of $100,000 from loans and investments made in the ordinary course of S's mortgage banking business. This includes, for example, mortgage servicing fees, interest earned on mortgages prior to sale of the mortgages, and gain on sale of mortgages. In addition, S receives, from the investment of idle funds in short-term securities, $15,000 of gross interest income and $5,000 of gain.

(ii) S's gross receipts are calculated as follows:

 $100,000  Gross receipts from operations

 $ 15,000  Gross interest receipts

SECTION 1.1362-3 TREATMENT OF S TERMINATION YEAR.

(a) IN GENERAL. If an S election terminates under section 1362(d) on a date other than the first day of a taxable year of the corporation, the corporation's taxable year in which the termination occurs is an S termination year. The portion of the S termination year ending at the close of the day prior to the termination is treated as a short taxable year for which the corporation is an S corporation (the S SHORT YEAR). The portion of the S termination year beginning on the day the termination is effective is treated as a short taxable year for which the corporation is a C corporation (the C SHORT YEAR). Except as provided in paragraphs (b) and (c)(1) of this section, the corporation allocates income or loss for the entire year on a pro rata basis as described in section 1362(e)(2). To the extent that income or loss is not allocated on a pro rata basis under this section, items of income, gain, loss, deduction, and credit are assigned to each short taxable year on the basis of the corporation's normal method of accounting as determined under section 446.

(b) ALLOCATIONS OTHER THAN PRO RATA -- (1) ELECTIONS UNDER SECTION 1362(e)(3). The pro rata allocation rules of section 1362(e)(2) do not apply if the corporation elects to allocate its S termination year income on the basis of its normal tax accounting method. This election may be made only with the consent of each person who is a shareholder in the corporation at any time during the S short year and of each person who is a shareholder in the corporation on the first day of the C short year. See section 1.1362-6(a) for rules concerning the time and manner of making this election.

(2) PURCHASE OF STOCK TREATED AS AN ASSET PURCHASE. The pro rata allocation rules of section 1362(e)(2) do not apply with respect to any item resulting from the application of section 338.

(3) 50 PERCENT CHANGE IN OWNERSHIP DURING S TERMINATION YEAR. The pro rata allocation rules of section 1362(e)(2) do not apply if at any time during the S termination year, as a result of sales or exchanges of stock in the corporation during that year, there is a change in ownership of 50 percent or more of the issued and outstanding shares of stock of the corporation. If stock has already been sold or exchanged during the S termination year, subsequent sales or exchanges of that stock are not taken into account for purposes of this paragraph (b)(3).

(c) SPECIAL RULES -- (1) S CORPORATION THAT IS A PARTNER IN A PARTNERSHIP. For purposes of section 706(c) only, the termination of the election of an S corporation that is a partner in a partnership during any portion of the S short year under section 1.1362-2(a) or (b), is treated as a sale or exchange of the corporation's entire interest in the partnership on the last day of the S short year, if --

(i) The pro rata allocation rules do not apply to the corporation; and

(ii) Any taxable year of the partnership ends with or within the C short year.

(2) TAX FOR THE C SHORT YEAR. The taxable income for the C short year is determined on an annualized basis as described in section 1362(e)(5).

(3) EACH SHORT YEAR TREATED AS TAXABLE YEAR. Except as otherwise provided in paragraph (c)(4) of this section, the S and C short years are treated as two separate years for purposes of all provisions of the Internal Revenue Code.

(4) YEAR FOR CARRYOVER PURPOSES. The S and C short years are treated as one year for purposes of determining the number of taxable years to which any item may be carried back or forward by the corporation.

(5) DUE DATE FOR S SHORT YEAR RETURN. The date by which the return for the S short year must be filed is the same as the date by which the return for the C short year must be filed (including extensions).

(6) YEAR IN WHICH INCOME FROM S SHORT YEAR IS INCLUDIBLE. A shareholder must include in taxable income the shareholder's pro rata share of the items described in section 1366(a) for the S short year for the taxable year with or within which the S termination year ends.

(d) EXAMPLES. The provisions of this section are illustrated by the following examples:

EXAMPLE 1. S TERMINATION YEAR NOT CREATED. (i) On January 1, 1993, the first day of its taxable year, a subchapter C corporation had three eligible shareholders. During 1993, the corporation properly elected to be treated as an S corporation effective January 1, 1994, the first day of the succeeding taxable year. Subsequently, a transfer of some of the stock in the corporation was made to an ineligible shareholder. The ineligible shareholder still holds the stock on January 1, 1994.

(ii) The corporation fails to meet the definition of a small business corporation on January 1, 1994, and its election is treated as having terminated on that date. See section 1.1362-2(b)(2) for the termination rules. Because the corporation ceases to be a small business corporation on the first day of a taxable year, an S termination year is not created. In addition, if the corporation in the future meets the definition of a small business corporation and desires to elect to be treated as an S corporation, the corporation is automatically granted consent to reelect before the expiration of the 5-year waiting period. See section 1.1362-5 for special rules concerning automatic consent to reelect.

EXAMPLE 2. MORE THAN 50 PERCENT CHANGE IN OWNERSHIP DURING S SHORT YEAR. A, an individual, owns all 100 outstanding shares of stock of S, a calendar year S corporation. On January 31, 1993, A sells 60 shares of S stock to B, an individual. On June 1, 1993, A sells 5 shares of S stock to PRS, a partnership. S ceases to be a small business corporation on June 1, 1993, and pursuant to section 1362(d)(2), its election terminates on that date. Because there was a more than 50 percent change in ownership of the issued and outstanding shares of S stock, S must assign the items of income, loss, deduction, or credit for the S termination year to the two short taxable years on the basis of S's normal method of accounting under the rules of paragraph (b)(3) of this section.

EXAMPLE 3. MORE THAN 50 PERCENT CHANGE IN OWNERSHIP DURING C SHORT YEAR. A, an individual, owns all 100 outstanding shares of stock of S, a calendar year S corporation. On June 1, 1993, A sells 5 shares of S stock to PRS, a partnership. S ceases to be a small business corporation on that date and pursuant to section 1362(d)(3), its election terminates on that date. On July 1, 1993, A sells 60 shares of S stock to B, an individual. Since there was a more than 50 percent change in ownership of the issued and outstanding shares of S stock during the S termination year, S must assign the items of income, loss, deduction, or credit for the S termination year to the two short taxable years on the basis of S's normal method of accounting under the rules of paragraph (b)(3) of this section.

EXAMPLE 4. STOCK ACQUIRED OTHER THAN BY SALE OR EXCHANGE. C and D are shareholders in S, a calendar year S corporation. Each owns 50 percent of the issued and outstanding shares of the corporation on December 31, 1993. On March 1, 1994, C makes a gift of his entire shareholder interest to T, a trust not permitted as a shareholder under section 1361(c)(2). S ceases to be a small business corporation on March 1, 1994, and pursuant to section 1362(d)(2), its S corporation election terminates effective on that date. As a result of the gift, T owns 50 percent of S's issued and outstanding stock. However, because T acquired the stock by gift from C rather than by sale or exchange, there has not been a more than 50 percent change in ownership by sale or exchange of S that would cause the rules of paragraph (b)(3) of this section to apply.

SECTION 1.1362-4 INADVERTENT TERMINATIONS.

(a) IN GENERAL. A corporation is treated as continuing to be an S corporation during the period specified by the Commissioner if --

(1) The corporation made a valid election under section 1362(a) and the election terminated;

(2) The Commissioner determines that the termination was inadvertent;

(3) Steps were taken by the corporation to return to small business corporation status within a reasonable period after discovery of the terminating event; and

(4) The corporation and shareholders agree to adjustments that the Commissioner may require for the period.

(b) INADVERTENT TERMINATION. For purposes of paragraph (a) of this section, the determination of whether a termination was inadvertent is made by the Commissioner. The corporation has the burden of establishing that under the relevant facts and circumstances the Commissioner should determine that the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the event took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event, tends to establish that the termination was inadvertent.

(c) CORPORATION'S REQUEST FOR DETERMINATION OF AN INADVERTENT TERMINATION. A corporation that believes its election was terminated inadvertently may request a determination of inadvertent termination from the Commissioner. The request is made in the form of a ruling request and should set forth all relevant facts pertaining to the event including, but not limited to, the facts described in paragraph (b) of this section, the date of the corporation's election under section 1362(a), a detailed explanation of the event causing termination, when and how the event was discovered, and the steps taken to return the corporation to small business corporation status.

(d) ADJUSTMENTS. The Commissioner may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the Commissioner. In the case of a transfer of stock to an ineligible shareholder that causes an inadvertent termination under section 1362(f), the Commissioner may require the ineligible shareholder to be treated as a shareholder of an S corporation during the period the ineligible shareholder actually held stock in the corporation. Moreover, the Commissioner may require protective adjustments that prevent any loss of revenue due to a transfer of stock to an ineligible shareholder (e.g., a transfer to a nonresident alien).

(e) CORPORATION AND SHAREHOLDER CONSENTS. The corporation and all persons who were shareholders of the corporation at any time during the period specified by the Commissioner must consent to any adjustments that the Commissioner may require. Each consent should be in the form of a statement agreeing to make the adjustments. The statement must be signed by the shareholder (in the case of shareholder consent) or a person authorized to sign the return required by section 6037 (in the case of corporate consent). See section 1.1362-6(b)(2) for persons required to sign consents. A shareholder's consent statement should include the name, address, and taxpayer identification numbers of the corporation and shareholder, the number of shares of stock owned by the shareholder, and the dates on which the shareholder owned any stock. The corporate consent statement should include the name, address, and taxpayer identification numbers of the corporation and each shareholder.

(f) STATUS OF CORPORATION. The status of the corporation after the terminating event and before the determination of inadvertence is determined by the Commissioner. Inadvertent termination relief may be granted retroactive for all years for which the terminating event was effective, in which case the corporation is treated as if its election had not terminated. Alternatively, relief may be granted only for the period in which the corporation again became eligible for subchapter S treatment, in which case the corporation is treated as a C corporation during the period for which the corporation was not eligible to be an S corporation.

SECTION 1.1362-5 ELECTION AFTER TERMINATION.

(a) IN GENERAL. Absent the Commissioner's consent, an S corporation whose election has terminated (or a successor corporation) may not make a new election under section 1362(a) for five taxable years as described in section 1362(g). However, the Commissioner may permit the corporation to make a new election before the 5-year period expires. The corporation has the burden of establishing that under the relevant facts and circumstances, the Commissioner should consent to a new election. The fact that more than 50 percent of the stock in the corporation is owned by persons who did not own any stock in the corporation on the date of the termination tends to establish that consent should be granted. In the absence of this fact, consent ordinarily is denied unless the corporation shows that the event causing termination was not reasonably within the control of the corporation or shareholders having a substantial interest in the corporation and was not part of a plan on the part of the corporation or of such shareholders to terminate the election.

(b) SUCCESSOR CORPORATION. A corporation is a SUCCESSOR CORPORATION to a corporation whose election under section 1362 has been terminated if --

(1) 50 percent or more of the stock of the corporation (the new corporation) is owned, directly or indirectly, by the same persons who, on the date of the termination, owned 50 percent or more of the stock of the corporation whose election terminated (the old corporation); and

(2) Either the new corporation acquires a substantial portion of the assets of the old corporation, or a substantial portion of the assets of the new corporation were assets of the old corporation.

(c) AUTOMATIC CONSENT AFTER CERTAIN TERMINATIONS. A corporation may, without requesting the Commissioner's consent, make a new election under section 1362(a) before the 5-year period described in section 1362(g) expires if the termination occurred because the corporation --

(1) Revoked its election effective on the first day of the first taxable year for which its election was to be effective (see section 1.1362-2(a)(2)); or

(2) Failed to meet the definition of a small business corporation on the first day of the first taxable year for which its election was to be effective (see section 1.1362-2(b)(2)).

SECTION 1.1362-6 ELECTIONS AND CONSENTS.

(a) TIME AND MANNER OF MAKING ELECTIONS -- (1) IN GENERAL. An election statement made under this section must identify the election being made, set forth the name, address, and taxpayer identification number of the corporation, and be signed by a person authorized to sign the return required to be filed under section 6037.

(2) ELECTION TO BE AN S CORPORATION -- (i) MANNER OF MAKING ELECTION. A small business corporation makes an election under section 1362(a) to be an S corporation by filing a completed Form 2553. The election form must be filed with the service center designated in the instructions applicable to Form 2553. The election is not valid unless all shareholders of the corporation at the time of the election consent to the election in the manner provided in paragraph (b) of this section. However, once a valid election is made, new shareholders need not consent to that election.

(ii) TIME OF MAKING ELECTION -- (A) IN GENERAL. The election described in paragraph (a)(2)(i) of this section may be made by a small business corporation at any time during the taxable year that immediately precedes the taxable year for which the election is to be effective, or during the taxable year for which the election is to be effective provided that the election is made before the 16th day of the third month of the year. If a corporation makes an election for a taxable year, and the election meets all the requirements of this section but is made during the period beginning after the 15th day of the third month of the taxable year, the election is treated as being made for the following taxable year provided that the corporation meets all the requirements of section 1361(b) at the time the election is made. For taxable years of 2-1/2 months or less, an election made before the 16th day of the third month after the first day of the taxable year is treated as made during that year.

(B) ELECTIONS MADE DURING THE FIRST 2-1/2 MONTHS TREATED AS MADE FOR THE FOLLOWING TAXABLE YEAR. A timely election made by a small business corporation during the taxable year for which it is intended to be effective is nonetheless treated as made for the following taxable year if --

(1) The corporation is not a small business corporation during the entire portion of the taxable year which occurs before the date the election is made; or

(2) Any person who held stock in the corporation at any time during the portion of the taxable year which occurs before the time the election is made, and who does not hold stock at the time the election is made, does not consent to the election.

(C) DEFINITION OF MONTH AND BEGINNING OF THE TAXABLE YEAR. MONTH means a period commencing on the same numerical day of any calendar month as the day of the calendar month on which the taxable year began and ending with the close of the day preceding the numerically corresponding day of the succeeding calendar month or, if there is no corresponding day, with the close of the last day of the succeeding calendar month. In addition, the taxable year of a new corporation begins on the date that the corporation has shareholders, acquires assets, or begins doing business, whichever is the first to occur. The existence of incorporators does not necessarily begin the taxable year of a new corporation.

(iii) EXAMPLES. The provisions of this section are illustrated by the following examples:

EXAMPLE 1. EFFECTIVE ELECTION; NO PRIOR TAXABLE YEAR. A calendar year small business corporation begins its first taxable year on January 7, 1993. To be an S corporation beginning with its first taxable year, the corporation must make the election set forth in this section during the period that begins January 7, 1993, and ends before March 22, 1993. Because the corporation had no taxable year immediately preceding the taxable year for which the election is to be effective, an election made earlier than January 7, 1993, will not be valid.

EXAMPLE 2. EFFECTIVE ELECTION; TAXABLE YEAR LESS THAN 2-1/2 MONTHS. A calendar year small business corporation begins its first taxable year on November 8, 1993. To be an S corporation beginning with its first taxable year, the corporation must make the election set forth in this section during the period that begins November 8, 1993, and ends before January 23, 1994.

EXAMPLE 3. ELECTION EFFECTIVE FOR THE FOLLOWING TAXABLE YEAR; INELIGIBLE SHAREHOLDER. On January l, 1993, two individuals and a partnership own all of the stock of a calendar year subchapter C corporation. On January 31, 1993, the partnership dissolved and distributed its shares in the corporation to its five partners, all individuals. On February 28, 1993, the seven shareholders of the corporation consented to the corporation's election of subchapter S status. The corporation files a properly completed Form 2553 on March 2, 1993. The corporation is not eligible to be a subchapter S corporation for the 1993 taxable year because during the period of the taxable year prior to the election it had an ineligible shareholder. However, under paragraph (a)(2)(ii)(B) of this section, the election is treated as made for the corporation's 1994 taxable year.

(3) REVOCATION OF S ELECTION -- (i) MANNER OF REVOKING ELECTION. To revoke an election, the corporation files a statement that the corporation revokes the election made under section 1362(a). The statement must be filed with the service center where the election was properly filed. The revocation statement must include the number of shares of stock (including non-voting stock) issued and outstanding at the time the revocation is made. A revocation may be made only with the consent of shareholders who, at the time the revocation is made, hold more than one-half of the number of issued and outstanding shares of stock (including non-voting stock) of the corporation. Each shareholder who consents to the revocation must consent in the manner required under paragraph (b) of this section. In addition, each consent should indicate the number of issued and outstanding shares of stock (including non-voting stock) held by each shareholder at the time of the revocation.

(ii) TIME OF REVOKING ELECTION. For rules concerning when a revocation is effective, see section 1.1362-2(a)(2).

(iii) EXAMPLES. The principles of this paragraph (a)(3) are illustrated by the following examples:

EXAMPLE 1. REVOCATION; CONSENT OF SHAREHOLDERS OWNING MORE THAN ONE-HALF OF ISSUED AND OUTSTANDING SHARES. A calendar year S corporation has issued and outstanding 40,000 shares of class A voting common stock and 20,000 shares of class B non-voting common stock. The corporation wishes to revoke its election of subchapter S status. Shareholders owning 11,000 shares of class A stock sign revocation consents. Shareholders owning 20,000 shares of class B stock sign revocation consents. The corporation has obtained the required shareholder consent to revoke its subchapter S election because shareholders owning more than one-half of the total number of issued and outstanding shares of stock of the corporation consented to the revocation.

EXAMPLE 2. EFFECTIVE PROSPECTIVE REVOCATION. In June 1993, a calendar year S corporation determines that it will revoke its subchapter S election effective August 1, 1993. To do so it must file its revocation statement with consents attached on or before August 1, 1993, and the statement must indicate that the revocation is intended to be effective August l, 1993.

(4) RESCISSION OF A REVOCATION -- (i) MANNER OF RESCINDING A REVOCATION. To rescind a revocation, the corporation files a statement that the corporation rescinds the revocation made under section 1362(d)(1). The statement must be filed with the service center where the revocation was properly filed. A rescission may be made only with the consent (in the manner required under paragraph (b)(1) of this section) of each person who consented to the revocation and of each person who became a shareholder of the corporation within the period beginning on the first day after the date the revocation was made and ending on the date on which the rescission is made.

(ii) TIME OF RESCINDING A REVOCATION. If the rescission statement is filed before the revocation becomes effective and is filed with proper service center, the rescission is effective on the date it is so filed.

(5) ELECTION NOT TO APPLY PRO RATA ALLOCATION. To elect not to apply the pro rata allocation rules to an S termination year, a corporation files a statement that it elects under section 1362(e)(3) not to apply the rules provided in section 1362(e)(2). In addition to meeting the requirements of paragraph (a)(1) of this section, the statement must set forth the cause of the termination and the date thereof. The statement must be filed with the corporation's return for the C short year. This election may be made only with the consent of all persons who are shareholders of the corporation at any time during the S short year and all persons who are shareholders of the corporation on the first day of the C short year (in the manner required under paragraph (b)(1) of this section).

(b) SHAREHOLDERS' CONSENTS -- (1) MANNER OF CONSENTS IN GENERAL. A shareholder's consent required under paragraph (a) of this section must be in the form of a written statement that sets forth the name, address, and taxpayer identification number of the shareholder, the number of shares of stock owned by the shareholder, the date (or dates) on which the stock was acquired, the date on which the shareholder's taxable year ends, the name of the S corporation, the corporation's taxpayer identification number, and the election to which the shareholder consents. The statement must be signed by the shareholder under penalties of perjury. Except as provided in paragraph (b)(3)(iii) of this section, the election of the corporation is not valid if any required consent is not filed in accordance with the rules contained in this paragraph (b). The consent statement should be attached to the corporation's election statement.

(2) PERSONS REQUIRED TO CONSENT. The following rules apply in determining persons required to consent:

(i) COMMUNITY INTEREST IN STOCK. When stock of the corporation is owned by husband and wife as community property (or the income from the stock is community property), or is owned by tenants in common, joint tenants, or tenants by the entirety, each person having a community interest in the stock or income therefrom and each tenant in common, joint tenant and tenant by the entirety must consent to the election.

(ii) MINOR. The consent of a minor must be made by the minor or by the legal representative of the minor (or by a natural or an adoptive parent of the minor if no legal representative has been appointed).

(iii) ESTATE. The consent of an estate must be made by an executor or administrator thereof, or by any other fiduciary appointed by testamentary instrument or appointed by the court having jurisdiction over the administration of the estate.

(iv) TRUST. In the case of a trust described in section 1361(c)(2)(A) (including a trust treated under section 1361(d)(1)(A) as a trust described in section 1361(c)(2)(A)(i)), only the person treated as the shareholder for purposes of section 1361(b)(1) must consent to the election. When stock of the corporation is held by a trust, both husband and wife must consent to any election if the husband and wife have a community interest in the trust property. See paragraph (b)(2)(i) of this section for rules concerning community interests in S corporation stock.

(3) SPECIAL RULES FOR CONSENT OF SHAREHOLDER TO ELECTION TO BE AN S CORPORATION -- (i) IN GENERAL. The consent of a shareholder to an election by a small business corporation under section 1362(a) may be made on Form 2553 or on a separate statement in the manner described in paragraph (b)(1) of this section. In addition, the separate statement must set forth the name, address, and taxpayer identification number of the corporation. A shareholder's consent is binding and may not be withdrawn after a valid election is made by the corporation. Each person who is a shareholder (including any person who is treated as a shareholder under section 1361(c)(2)(B)) at the time the election is made) must consent to the election. If the election is made before the 16th day of the third month of the taxable year and is intended to be effective for that year, each person who was a shareholder (including any person who was treated as a shareholder under section 1361(c)(2)(B)) at any time during the portion of that year which occurs before the time the election is made, and who is not a shareholder at the time the election is made, must also consent to the election. If the election is to be effective for the following taxable year, no consent need be filed by any shareholder who is not a shareholder on the date of the election. Any person who is considered to be a shareholder under applicable state law solely by virtue of his or her status as an incorporator is not treated as a shareholder for purposes of this paragraph (b)(3)(i).

(ii) EXAMPLES. The principles of this section are illustrated by the following examples:

EXAMPLE 1. EFFECTIVE ELECTION; SHAREHOLDER CONSENTS. On January 1, 1993, the first day of its taxable year, a subchapter C corporation had 15 shareholders. On January 30, 1993, two of the C corporation's shareholders, A and B, both individuals, sold their shares in the corporation to P, Q, and R, all individuals. On March 1, 1993, the corporation filed its election to be an S corporation for the 1993 taxable year. The election will be effective (assuming the other requirements of section 1361(b) are met) provided that all of the shareholders as of March 1, 1993, as well as former shareholders A and B, consent to the election.

EXAMPLE 2. CONSENT OF NEW SHAREHOLDER UNNECESSARY. On January 1, 1993, three individuals own all of the stock of a calendar year subchapter C corporation. On April 15, 1993 the corporation, in accordance with paragraph (a)(2) of this section, files a properly completed Form 2553. The corporation anticipates that the election will be effective beginning January 1, 1994, the first day of the succeeding taxable year. On October 1, 1993, the three shareholders collectively sell 75% of their shares in the corporation to another individual. On January 1, 1994, the corporation's shareholders are the three original individuals and the new shareholder. Because the election was valid and binding when made, it is not necessary for the new shareholder to consent to the election. The corporation's subchapter S election is effective on January 1, 1994 (assuming the other requirements of section 1361(b) are met).

(iii) EXTENSION OF TIME FOR FILING CONSENTS TO AN ELECTION -- (A) IN GENERAL. An election that is timely filed for any taxable year and that would be valid except for the failure of any shareholder to file a timely consent is not invalid if consents are filed as required under paragraph (b)(3)(iii)(B) of this section and it is shown to the satisfaction of the district director or director of the service center with which the corporation files its income tax return that --

(1) There was reasonable cause for the failure to file the consent;

(2) The request for the extension of time to file a consent is made within a reasonable time under the circumstances; and

(3) The interests of the Government will not be jeopardized by treating the election as valid.

(B) REQUIRED CONSENTS. Consents must be filed within the extended period of time as may be granted by the Internal Revenue Service, by all persons who --

(1) Were shareholders of the corporation at any time during the period beginning as of the date of the invalid election and ending on the date on which an extension of time is granted in accordance with this paragraph (b)(3)(iii); and

(2) Have not previously consented to the election.

SECTION 1.1362-7 EFFECTIVE DATE.

(a) IN GENERAL. The provisions of sections 1.1362-1 through 1.1362-6 apply to taxable years of corporations beginning after December 31, 1992. For taxable years to which these regulations do not apply, corporations and shareholders subject to the provisions of section 1362 must take reasonable return positions taking into consideration the statute; its legislative history; the provisions of sections 18.1362-1 through 18.1362-5 (see 26 CFR part 18 as contained in the CFR edition revised as of April 1, 1992). In addition, following these regulations is a reasonable return position. See Notice 92-56, 1992-49 I.R.B. (see section 601.601(d)(2)(ii)(b) of this chapter), for additional guidance regarding reasonable return positions for years to which sections 1.1362-1 through 1.1362-6 do not apply.

(b) SPECIAL EFFECTIVE DATE FOR PASSIVE INVESTMENT INCOME PROVISIONS. For taxable years of an S corporation and all affected shareholders that are not closed, the S corporation and all affected shareholders may elect to apply the provisions of section 1.1362-2(c)(5). To make the election, the corporation and all affected shareholders must file a return or an amended return that is consistent with these rules for the taxable year for which the election is made and each subsequent taxable year. For purposes of this section, AFFECTED SHAREHOLDERS means all shareholders who received distributive shares of S corporation items in the taxable year for which the election is made and all shareholders of the S corporation for all subsequent taxable years. However, the Commissioner may, in appropriate circumstances, permit taxpayers to make this election even if all affected shareholders cannot file consistent returns.

SECTION 1.1363-1 EFFECT OF ELECTION ON CORPORATION.

(a) EXEMPTION OF CORPORATION FROM INCOME TAX -- (1) IN GENERAL. Except as provided in this paragraph (a), a small business corporation that makes a valid election under section 1362(a) is exempt from the taxes imposed by chapter 1 of the Internal Revenue Code with respect to taxable years of the corporation for which the election is in effect.

(2) CORPORATE LEVEL TAXES. An S corporation is not exempt from the tax imposed by section 1374 (relating to the tax imposed on certain built-in gains), or section 1375 (relating to the tax on excess passive investment income). See also section 1363(d) (relating to the recapture of LIFO benefits) for the rules regarding the payment by an S corporation of LIFO recapture amounts.

(b) COMPUTATION OF CORPORATE TAXABLE INCOME. The taxable income of an S corporation is computed as described in section 1363(b).

(c) ELECTIONS OF THE S CORPORATION -- (1) IN GENERAL. Any elections (other than those described in paragraph (c)(2) of this section) affecting the computation of items derived from an S corporation are made by the corporation. For example, elections of methods of accounting, of computing depreciation, of treating soil and water conservation expenditures, and the option to deduct as expenses intangible drilling and development costs, are made by the corporation and not by the shareholders separately. All corporate elections are applicable to all shareholders.

(2) EXCEPTIONS. (i) Each shareholder's pro rata share of expenses described in section 617 paid or accrued by the S corporation is treated according to the shareholder's method of treating those expenses, notwithstanding the treatment of the expenses by the corporation.

(ii) Each shareholder may elect to amortize that shareholder's pro rata share of any qualified expenditure described in section 59(e) paid or accrued by the S corporation.

(iii) Each shareholder's pro rata share of taxes described in section 901 paid or accrued by the S corporation to foreign countries or possessions of the United States (according to its method of treating those taxes) is treated according to the shareholder's method of treating those taxes, and each shareholder may elect to use the total amount either as a credit against tax or as a deduction from income.

(d) EFFECTIVE DATE. This section applies to taxable years of corporations beginning after December 31, 1992. For taxable years to which this section does not apply, corporations and shareholders subject to the provisions of section 1363 must take reasonable return positions taking into consideration the statute, its legislative history and these regulations. See Notice 92-56, 1992-49 I.R.B. (see section 601.601(d)(2)(ii)(b) of this chapter), for additional guidance regarding reasonable return positions for taxable years to which this section does not apply.

PART 18 -- TEMPORARY INCOME TAX REGULATIONS UNDER THE SUBCHAPTER S REVISION ACT OF 1982

Par. 3. The authority citation for part 18 is revised to read as follows:

Authority: 26 U.S.C. 7805 and sec. 6(c)(3)(B)(iii) of the Subchapter S Revision Act of 1982.

Par. 4. Sections 18.1362-1, 18-1362-2, 18.1362-3, 18.1362-4 and 18.1362-5 are removed.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT.

Par. 5. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 6. Section 602.101(c) is amended by removing the following entries from the table:

SECTION 602.101 OMB CONTROL NUMBERS.

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(c) * * *

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SECTION 602.101 OMB CONTROL NUMBERS.

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(c) * * *

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