Final Rules on S Corporation Built-In Gain

 [4830-01--u]

 ACTION: Final regulations.

 SUMMARY: This document prescribes final regulations under section 1374 relating to the tax imposed on an S corporation's net recognized built-in gain. The final regulations reflect changes to the law in the Tax Reform Act of 1986. The final regulations generally affect only corporations that changed from C to S status.

 DATES: These regulations are effective December 27, 1994.

 These regulations apply to taxable years ending on or after December 27, 1994, but only in cases where the return for the taxable year is filed pursuant to an S election or a section 1374(d)(8) transaction occurring on or after December 27, 1994.

 FOR FURTHER INFORMATION CONTACT: Mark S. Jennings or Lee D. Muchnikoff, Office of Assistant Chief Counsel (Corporate), Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224 (Attention: CC:DOM:CORP:T:R), or telephone (202) 622-7530 (not a toll free number).

 SUPPLEMENTARY INFORMATION:

1. BACKGROUND

Section 1374 of the Internal Revenue Code of 1986 (Code) generally imposes a corporate-level tax on an S corporation's recognition of income or gain to the extent the income or gain reflects unrealized appreciation (or its equivalent) in the corporation when it converted from C to S status. Section 1374 was amended to provide this treatment as part of the legislation repealing the General Utilities rule. See H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess., Vol. II, 198-207 (1986), 1986-3 C.B., Vol. 4, 198-207.

 Section 1374 generally applies to an S corporation for taxable years beginning after December 31, 1986, but only if the corporation elects S status after December 31, 1986. Sections 1374(e) and 337(d) provide specific authority to promulgate regulations under section 1374.

 Proposed regulations under section 1374 were published in the Federal Register on December 8, 1992 (57 FR 57971, or 1992-2 C.B. 594). This document adds new sections 1.1374-0 through 1.1374-10 to 26 CFR Part 1.

2. SECTION 1374 AND THE PROPOSED REGULATIONS

 Section 1374(a) imposes a tax on an S corporation's net recognized built-in gain for any taxable year beginning in the 10-year recognition period following the S corporation's conversion from a C corporation or acquisition of C corporation assets in a carryover basis transaction. The proposed regulations provide that an S corporation's net recognized built-in gain for any taxable year is the least of (1) its taxable income determined by using the rules applying to C corporations and considering only recognized built-in gain and recognized built-in loss (the pre-limitation amount), (2) its taxable income determined by using the rules applying to C corporations and considering all items except as provided under section 1375(b)(1)(B) (the taxable income limitation), or (3) the excess of its net unrealized built-in gain over net recognized built-in gain for all prior taxable years in the recognition period (the net unrealized built-in gain limitation).

 Section 1374(d)(3) provides that any gain recognized on the disposition of an asset during the recognition period is recognized built-in gain except to the extent the S corporation establishes that it did not hold the asset on the first day of the recognition period or the asset appreciated after that day. Section 1374(d)(4) provides that any loss recognized on a disposition of an asset during the recognition period is recognized built-in loss to the extent the S corporation establishes that it held the asset on the first day of the recognition period and the asset depreciated before that day. The proposed regulations provide that sections 1374(d)(3) and (4) apply only to transactions treated as sales or exchanges under the Code.

 Section 1374(d)(5)(A) provides that any item of income properly taken into account during the recognition period but attributable to periods before the first day of the recognition period is recognized built-in gain. Section 1374(d)(5)(B) provides that any item of deduction properly taken into account during the recognition period but attributable to periods before the first day of the recognition period is recognized built-in loss. The proposed regulations provide that an S corporation's items of income or deduction generally are recognized built-in gain or loss if the item would have been included in gross income or allowed as a deduction against gross income before the recognition period by an accrual method taxpayer (accrual method rule). The proposed regulations provide that all rules applying to accrual method taxpayers (whether from the Code, regulations, administrative pronouncements, or otherwise) also apply for purposes of the accrual method rule with two exceptions: (1) section 461(h)(2)(C), relating to liabilities for tort and worker's compensation for which payment constitutes economic performance, and (2) section 469, relating to suspended passive activity losses. The proposed regulations also provide special rules for certain items including an S corporation's section 481(a) adjustments, income reported under the completed contract method, income reported under the installment method, and distributive share of partnership items.

 Section 1374(d)(1) provides that an S corporation's net unrealized built-in gain is the amount by which the fair market value of all its assets exceeds the aggregate adjusted bases of all its assets as of the beginning of the recognition period. Section 1374(d)(5)(C) provides that an S corporation's net unrealized built-in gain is properly adjusted for items of income and deduction that would be recognized built-in gain or loss if taken into account during the recognition period. The proposed regulations provide that the S corporation's net unrealized built-in gain is determined by reference to a hypothetical sale of all the assets of the corporation immediately before the beginning of the recognition period to a buyer that assumed all the corporation's liabilities.

 Section 1374(b)(2) provides that an S corporation's net operating loss carryforwards and capital loss carryforwards arising in years for which the corporation was a C corporation are allowed as deductions against net recognized built-in gain. The proposed regulations provide that no other loss carryforwards may be used as a deduction against net recognized built-in gain. Section 1374(b)(3) provides that an S corporation's special fuels credit for the year, and business credit carryforwards and minimum tax credit arising in years for which the corporation was a C corporation, are allowed as credits against the section 1374 tax. The proposed regulations provide that no other credits or credit carryforwards may be used as a credit against the section 1374 tax. The loss carryforwards, credits, and credit carryforwards allowed to reduce the section 1374 tax are collectively referred to as the section 1374 attributes in the final regulations.

3. PUBLIC COMMENTS AND THE FINAL REGULATIONS

 The IRS received written and oral comments from the public on the proposed regulations both in connection with the public hearing held on April 28, 1993, and otherwise. The issues raised by these comments are discussed below.

 A. ACCOUNTING METHODS

Commentators request guidance about the accounting methods an S corporation should use in determining its pre-limitation amount and taxable income limitation. The commentators suggest that an S corporation should be allowed to use any accounting method it could use if it were a C corporation. The final regulations do not adopt this suggestion because section 1374 applies only to items an S corporation actually takes into account during the recognition period. It does not apply to items the corporation would have taken into account under a hypothetical method of accounting. Accordingly, the final regulations require the S corporation to use the accounting methods it actually uses as an S corporation to make these taxable income determinations.

 B. RECOGNITION PERIOD

Commentators request confirmation that the recognition period is the 10 calendar year period (and not the 10 taxable year period) beginning on the first day the corporation is an S corporation or the day the S corporation acquires C corporation assets in a carryover basis transaction. The final regulations confirm the commentators' interpretation of the Code.

 Commentators also request guidance on determining an S corporation's net recognized built-in gain where the recognition period ends during a taxable year (for example, because a corporation converting from C to S status was on a fiscal year as a C corporation and changed to a calendar year as an S corporation or because an S corporation acquired C corporation assets in a carryover basis transaction during a taxable year). The final regulations provide that the pre-limitation amount for the year is determined by a closing of the books at the end of the recognition period.

 C. ACCRUAL METHOD RULE AND SECTION 267(a)(2) OR 404(a)(5)

One commentator argues that the proposed regulations should not use the accrual method rule to determine if, and the extent to which, an item of income or deduction is included in net recognized built-in gain. Instead, this commentator argues that the approach the proposed regulations use to determine if, and the extent to which, an item of income or deduction is included in net unrealized built-in gain (that is, by valuation using a hypothetical sale of all the S corporation's assets to a buyer that assumes all the S corporation's liabilities) should also be used to determine if, and the extent to which, an item of income or deduction is included in net recognized built-in gain.

 The Treasury and the IRS believe that separately valuing each item of income and deduction for net recognized built-in gain purposes would be unduly burdensome both for taxpayers and for the IRS. Using a valuation approach for determining net unrealized built-in gain is not unduly burdensome because net unrealized built- in gain can be determined by valuing the S corporation's business using an aggregate approach where particular items of income and deduction are not valued individually. In addition, many S corporations subject to section 1374 will not need to know their net unrealized built-in gain because they will not approach their net unrealized built-in gain limitation in the recognition period. However, most S corporations subject to section 1374 will have items of income and deduction taken into account in the recognition period where a determination must be made if, and the extent to which, the item is included in net recognized built-in gain. Accordingly, the final regulations do not adopt the commentator's suggestion and generally retain the accrual method rule in the proposed regulations.

 Some commentators argue that the accrual method rule in the proposed regulations wrongly applies sections 267(a)(2), relating to accrued amounts payable to related persons, and 404(a)(5), relating to accrued amounts payable as deferred compensation, to determine whether an item of deduction should be treated as a recognized built- in loss. In general, those sections defer a deduction for an accrual method taxpayer that owes a payment to a cash method taxpayer until the payment is made. The commentators cite the following statement in the section 1374 legislative history in support of their position:

As an example of these built-in gain and loss provisions, in the case of a cash basis personal service corporation that converts to S status and that has receivables at the time of the conversion, the receivables, when received, are built-in gain items. At the same time, built-in losses would include otherwise deductible compensation paid after the conversion to the persons who performed the services that produced the receivables, to the extent such compensation is attributable to such pre-conversion services. To the extent such built-in loss items offset the built-in gains from the receivables, there would be no amount subject to the built-in gains tax.

H.R. Rep. No. 795, 100th Cong., 2d Sess. 63-64 (1988).

 The commentators suggest that the accrual method rule in the final regulations should be applied without regard to sections 267(a)(2) and 404(a)(5). The Treasury and the IRS disagree with the commentators that the legislative history quoted above precludes the adoption of the accrual method rule of the proposed regulations. The accrual method rule in the proposed regulations was adopted as an administrable method for both taxpayers and the Service to determine the extent to which an amount included in income or deducted in the recognition period is attributable to the pre-recognition period. Nevertheless, in response to the commentators' requests, the final regulations extend recognized built-in loss treatment for certain amounts properly deducted under section 267(a)(2) or 404(a)(5) in the recognition period.

 The final regulations provide that an amount properly deducted under section 267(a)(2) is recognized built-in loss to the extent (i) all events have occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability can be determined, as of the beginning of the recognition period, and (ii) the amount is paid in the first two and one-half months of the recognition period, or is paid to an individual that owned less than 5 percent of the corporation's stock. The final regulations provide that an amount properly deducted under section 404(a)(5) is recognized built-in loss to the extent (i) all events have occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability can be determined, as of the beginning of the recognition period, and (ii) the amount is not deductible under section 267(a)(2). The Treasury and the IRS believe that these rules are relatively easy for taxpayers and the IRS to apply and also provide relief from the deferral of deductions under section 267(a)(2) or 404(a)(5). The additional limitations for amounts deducted under section 267(a)(2) are needed because of the particular difficulty in determining whether amounts paid to related parties are attributable to services performed before or after the beginning of the recognition period.

 The final regulations also modify the accrual method rule in the proposed regulations as follows: (1) an exception from the accrual method rule for items deducted under section 1.461-4(g) is added (relating to items in addition to those specified in section 461(h)(2)(C) for which payment constitutes economic performance); and (2) the exception from the accrual method rule in the proposed regulations for items deducted under section 469 is eliminated. The section 1.461-4(g) exception is added to clarify the section 461(h)(2)(C) exception in the proposed regulations. The section 469 exception is eliminated because losses suspended before the recognition period under section 469 cannot be used in the recognition period under section 1371(b)(1).

 D. SECTION 481 ADJUSTMENTS

The proposed regulations provide that any item of income or deduction properly taken into account during the recognition period under section 481 is recognized built-in gain or loss if the item is taken into account because of a change of accounting method effective before the beginning of the second year of the recognition period ("one-year rule"). In certain cases, this one-year rule has the effect of (1) omitting income attributable to the corporation's C period altogether at the corporate level, (2) including income attributable to the corporation's C period twice at the corporate level, (3) omitting a deduction attributable to the corporation's C period altogether at the corporate level, or (4) allowing a deduction attributable to the corporation's C period twice at the corporate level, because the section 481 adjustment on the change in accounting method is not treated as recognized built-in gain or loss. In addition, the Treasury and the Service believe that in most cases the portion of a section 481(a) adjustment attributable to the pre- recognition period and the portion attributable to the recognition period can be determined without undue administrative difficulty.

 The final regulations, therefore, provide that any section 481(a) adjustment taken into account in the recognition period that prevents an omission or duplication of income or deduction is recognized built-in gain or loss to the extent the adjustment relates to items attributable to periods before the beginning of the recognition period under the principles for determining recognized built-in gain or loss in the regulations.

 E. INSTALLMENT METHOD

The proposed regulations impose a section 1374 tax on income reported under the installment method either during or after the recognition period in accordance with Notice 90-27, 1990-1 C.B. 336. The tax is imposed only to the extent the income would have been included in net recognized built-in gain if it had been reported in the year of the sale and all provisions of section 1374 applied including the taxable income limitation.

 Several commentators argue that the proposed regulations wrongly impose a section 1374 tax on income reported under the installment method after the recognition period. In addition, they contend that the proposed regulations wrongly apply the taxable income limitation by reference to the S corporation's cumulative taxable income from the year of the installment sale to the year that income is reported under the installment method (assuming the income had been reported in the year of the sale) instead of the S corporation's taxable income in the year that income was reported under the installment method. Further, they believe that, where income is reported under the installment method after the recognition period, the proposed regulations are unclear regarding the proper use of section 1374 attributes and loss recognized after the recognition period that would have been recognized built-in loss if it had been recognized during the recognition period.

 The final regulations retain the installment method rules in the proposed regulations because the Treasury and the IRS believe those rules are necessary to prevent an abuse of section 1374. The final regulations clarify the use of an S corporation's section 1374 attributes and loss recognized after the recognition period where income is reported under the installment method for a year after the recognition period. Section 1374 attributes may be used to the extent their use is allowed under all applicable provisions of the Code. However, the S corporation's loss recognized in a year after the recognition period may not be used to reduce the section 1374 tax.

 F. PARTNERSHIP ITEMS

The proposed regulations generally provide that an S corporation owning an interest in a partnership must treat its distributive share of the partnership's items as recognized built-in gain or loss to the extent the S corporation's distributive share would have been treated as recognized built-in gain or loss if the items originated in, and were taken into account directly by, the S corporation (the look- through rules). The look-through rules generally apply only to the extent the S corporation had built-in gain or built-in loss in its partnership interest at the beginning of the recognition period. The proposed regulations contain a small interest exception from the look-through rules for any taxable year where the S corporation's partnership interest has a value less than $100,000 and represents less than a 10 percent interest in the partnership's capital and profits at all times during the year. The small interest exception does not apply if the partnership was formed or availed of with a principal purpose to avoid the section 1374 tax. The proposed regulations provide that if an S corporation disposes of its partnership interest during the recognition period, the amount treated as recognized built-in gain or loss on the disposition is adjusted to take into account amounts treated as recognized built-in gain or loss under the look-through rules. The proposed regulations also provide special rules for section 704(c) gain and loss, and where an S corporation disposes of distributed partnership assets.

 Commentators argue that the look-through rules should apply only where an S corporation controls the partnership or the primary use of the partnership by the S corporation is to avoid section 1374 because, except where the S corporation is the controlling partner, the S corporation is not likely to have access to information and records necessary to identify and value partnership section 1374 items. In addition, the commentators suggest modifying the small interest exception to the look-through rules so that the small interest test is generally applied only on the first day of the recognition period. The commentators believe that subsequent increases or decreases in the fair market value of the partnership interest should be disregarded.

 The final regulations retain the look-through rules. Access to information and records necessary to identify and value partnership section 1374 items is not dependent on whether the S corporation is a controlling partner. Moreover, section 1374 should generally apply to an S corporation's partnership section 1374 items even where a principal purpose for using the partnership was not to avoid the section 1374 tax.

 The final regulations, however, modify the small interest exception to the look-through rules to accommodate the commentators' request for a rule requiring a valuation of the partnership interest only on the first day of the recognition period. Under the rule as modified, the small interest exception generally applies for a taxable year if the S corporation's interest in the partnership represents less than 10 percent of the partnership's profits and capital at all times during the taxable year and prior taxable years in the recognition period and has a value less than $100,000 as of the beginning of the recognition period. However, if the S corporation contributes an asset to the partnership in the recognition period and the S corporation held the asset as of the beginning of the recognition period, the fair market value of the S corporation's partnership interest as of the beginning of the recognition period is determined as if the asset was contributed to the partnership before the beginning of the recognition period (using the fair market value of the asset as of the beginning of the recognition period).

 G. VALUING INVENTORY

The proposed regulations provide that the value of an S corporation's inventory on the first day of the recognition period equals the amount that a willing buyer would pay a willing seller for the inventory in a purchase of all the S corporation's assets on that day. Commentators argue that the rules for valuing inventory in the proposed regulations are unclear and should be clarified to provide a non-liquidation, non-distress, bulk sale approach, which generally will result in a value for the inventory less than retail value.

 The final regulations provide that the value of an S corporation's inventory on the first day of the recognition period generally is determined by reference to a sale of the entire business of the S corporation to a buyer that expects to continue to operate that business. The buyer and seller are presumed not to be under any compulsion to buy or sell and to have reasonable knowledge of all relevant facts. Relevant facts include (1) the replacement cost of the inventory; (2) the expected retail selling price of the inventory; (3) the seller's incentive to demand a price for the inventory that would compensate for and provide a fair return for expenditures the seller incurred to obtain, prepare, carry, and dispose of the inventory before the sale of the business; and (4) the buyer's incentive to pay a price for the inventory that would compensate for and provide a fair return for similar expenditures the buyer expects to incur after the sale of the business. It is expected that the value of an S corporation's inventory as determined under the final regulations will generally be less than its anticipated retail price, but greater than its replacement cost.

 The preamble to the proposed regulations describes a safe harbor rule that was being considered for publication as a revenue procedure under which the value of inventory for purposes of section 1374 would be determined using a formula. One commentator endorsed the general idea of adopting a safe harbor rule, but objected to the rule described in the preamble and did not suggest an alternative rule. No commentators supported the rule described in the preamble of the proposed regulations or suggested an alternative rule.

 At this time, the IRS is not planning to issue a revenue procedure setting forth a safe harbor rule for valuing inventory. However, consideration will be given to any safe harbor rule taxpayers may suggest in the future.

 H. SECTION 1374(d)(8) TRANSACTIONS

Section 1374(d)(8) imposes a section 1374 tax if an S corporation acquires assets in a transaction where the S corporation's basis in the assets is determined by reference to their basis in the hands of a C corporation (a section 1374(d)(8) transaction) and, thereafter, the S corporation disposes of the assets. The proposed regulations provide that a separate determination of tax under section 1374 must be made for the assets acquired in each section 1374(d)(8) transaction. Thus, an S corporation's section 1374 attributes held on the day it became an S corporation may only be used to reduce a section 1374 tax imposed on dispositions of assets the S corporation held on that day. Similarly, section 1374 attributes acquired by an S corporation in a section 1374(d)(8) transaction may only be used to reduce a section 1374 tax imposed on dispositions of assets the S corporation acquired in the same transaction.

 Commentators argue that restrictions on the use of section 1374 attributes acquired by an S corporation in a section 1374(d)(8) transaction should not be greater than the restrictions that would apply if the attributes were acquired by a C corporation in a similar transaction. For example, commentators contend that an S corporation's net operating loss carryforwards when it changed from C to S status should be allowed to reduce a section 1374 tax imposed on assets the S corporation acquires in a section 1374(d)(8) transaction, subject to all statutory limits on their use including the anti-trafficking rules of sections 382, 383, and 384.

 The final regulations retain the rules in the proposed regulations. Section 1374(d)(8) imposes a section 1374 tax on the "net recognized built-in gain attributable to" the assets acquired in a particular transaction. The legislative history under section 1374 states that "each acquisition of assets from a C corporation is subject to a separate determination of the amount of net built-in gain . . . ." H.R. Rep. No. 795, 100th Cong., 2d Sess. 63 (1988).

 I. EFFECTIVE DATE AND ADDITIONAL RULES

The proposed regulations provide that the section 1374 final regulations will generally apply for taxable years ending on or after the date the final regulations are published in the Federal Register, but only where the return is filed pursuant to an S election or a section 1374(d)(8) transaction occurring on or after that date. The final regulations retain the effective date in the proposed regulations.

 The proposed regulations provide that if a taxpayer subject to section 1374, but not generally subject to the regulations, contributes an asset to a partnership under section 721(a) in contemplation of making an S election or during the recognition period, section 1374 applies on a disposition of the asset by the partnership as if the S corporation still owned the asset. This provision applies as of the effective date of section 1374. Commentators argue that the rule should apply only for contributions to partnerships after the proposed regulations were issued. The final regulations retain the rule in the proposed regulations to prevent an abuse of section 1374.

 The proposed regulations provide that the rules in Announcement 86-128, 1986-51 I.R.B. 22, and Notice 90-27, 1990-1 C.B. 336, apply to taxpayers subject to section 1374, but not generally subject to the regulations. Instead of referring to the rules in the Notice and the Announcement, the final regulations set forth some of the rules contained in those documents.

 Commentators suggest that the regulations allow taxpayers subject to section 1374, but not generally subject to the regulations, to elect to be subject to the regulations. The final regulations do not adopt this suggestion because of the burden of administering elections and because taxpayers not generally subject to the regulations nonetheless may take positions consistent with the regulations.

SPECIAL ANALYSIS

 It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Mark S. Jennings of the Office of Assistant Chief Counsel (Corporate), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

Treasury Decision 8579

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding the following entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 ***

 Section 1.1374-1 also issued under 26 U.S.C. 1374(e) and 337(d).

SECTION 1374 BEFORE THE TAX REFORM ACT OF 1986

SECTION 1.1374-1 [REDESIGNATED AS SECTION 1.1374-1A]

Par. 3. Section 1.1374-1 is redesignated as section 1.1374-1A and transferred under the new undesignated center heading.

Par. 4. Sections 1.1374-0 through 1.1374-10 are added to read as follows:

SECTION 1.1374-0 TABLE OF CONTENTS.

This section lists the major paragraph headings for sections 1.1374-1 through 1.1374-10.

 SECTION 1.1374-1  GENERAL RULES AND DEFINITIONS.

(a) COMPUTATION OF TAX. The tax imposed on the income of an S corporation by section 1374(a) for any taxable year during the recognition period is computed as follows--

(1) Step One: Determine the net recognized built-in gain of the corporation for the taxable year under section 1374(d)(2) and section 1.1374-2;

(2) Step Two: Reduce the net recognized built-in gain (but not below zero) by any net operating loss and capital loss carryforward allowed under section 1374(b)(2) and section 1.1374-5;

(3) Step Three: Compute a tentative tax by applying the rate of tax determined under section 1374(b)(1) for the taxable year to the amount determined under paragraph (a)(2) of this section;

(4) Step Four: Compute the final tax by reducing the tentative tax (but not below zero) by any credit allowed under section 1374(b)(3) and section 1.1374-6.

(b) ANTI-TRAFFICKING RULES. If section 382, 383, or 384 would have applied to limit the use of a corporation's recognized built-in loss or section 1374 attributes at the beginning of the first day of the recognition period if the corporation had remained a C corporation, these sections apply to limit their use in determining the S corporation's pre-limitation amount, taxable income limitation, net unrealized built-in gain limitation, deductions against net recognized built-in gain, and credits against the section 1374 tax.

(c) SECTION 1374 ATTRIBUTES. Section 1374 attributes are the loss carryforwards allowed under section 1374(b)(2) as a deduction against net recognized built-in gain and the credit and credit carryforwards allowed under section 1374(b)(3) as a credit against the section 1374 tax.

(d) RECOGNITION PERIOD. The recognition period is the 10-year (120-month) period beginning on the first day the corporation is an S corporation or the day an S corporation acquires assets in a section 1374(d)(8) transaction. For example, if the first day of the recognition period is July 14, 1996, the last day of the recognition period is July 13, 2006. If the recognition period for certain assets ends during an S corporation's taxable year (for example, because the corporation was on a fiscal year as a C corporation and changed to a calendar year as an S corporation or because an S corporation acquired assets in a section 1374(d)(8) transaction during a taxable year), the S corporation must determine its pre- limitation amount (as defined in section 1.1374-2(a)(1)) for the year as if the corporation's books were closed at the end of the recognition period.

(e) PREDECESSOR CORPORATION. For purposes of section 1374(c)(1), if the basis of an asset of the S corporation is determined (in whole or in part) by reference to the basis of the asset (or any other property) in the hands of another corporation, the other corporation is a predecessor corporation of the S corporation.

SECTION 1.1374-2 NET RECOGNIZED BUILT-IN GAIN.

(a) IN GENERAL. An S corporation's net recognized built-in gain for any taxable year is the least of --

(1) Its taxable income determined by using all rules applying to C corporations and considering only its recognized built-in gain, recognized built-in loss, and recognized built-in gain carryover (pre-limitation amount);

(2) Its taxable income determined by using all rules applying to C corporations as modified by section 1375(b)(1)(B) (taxable income limitation); and

(3) The amount by which its net unrealized built-in gain exceeds its net recognized built-in gain for all prior taxable years (net unrealized built-in gain limitation).

(b) ALLOCATION RULE. If an S corporation's pre-limitation amount for any taxable year exceeds its net recognized built-in gain for that year, the S corporation's net recognized built-in gain consists of a ratable portion of each item of income, gain, loss, and deduction included in the pre-limitation amount.

(c) RECOGNIZED BUILT-IN GAIN CARRYOVER. If an S corporation's net recognized built-in gain for any taxable year is equal to its taxable income limitation, the amount by which its pre-limitation amount exceeds its taxable income limitation is a recognized built-in gain carryover included in its pre-limitation amount for the succeeding taxable year. The recognized built-in gain carryover consists of that portion of each item of income, gain, loss, and deduction not included in the S corporation's net recognized built-in gain for the year the carryover arose, as determined under paragraph (b) of this section.

(d) ACCOUNTING METHODS. In determining its taxable income for pre-limitation amount and taxable income limitation purposes, a corporation must use the accounting method(s) it uses for tax purposes as an S corporation.

(e) EXAMPLE. The rules of this section are illustrated by the following example.

EXAMPLE. NET RECOGNIZED BUILT-IN GAIN. X is a calendar year C corporation that elects to become an S corporation on January 1, 1996. X has a net unrealized built-in gain of $50,000 and no net operating loss or capital loss carryforwards. In 1996, X has a pre-limitation amount of $20,000, consisting of ordinary income of $15,000 and capital gain of $5,000, a taxable income limitation of $9,600, and a net unrealized built-in gain limitation of $50,000. Therefore, X's net recognized built-in gain for 1996 is $9,600, because that is the least of the three amounts described in paragraph (a) of this section. Under paragraph (b) of this section, X's net recognized built-in gain consists of recognized built-in ordinary income of $7,200 [$15,000 x ($9,600/$20,000) = $7,200] and recognized built-in capital gain of $2,400 [$5,000 x ($9,600/$20,000) = $2,400]. Under paragraph (c) of this section, X has a recognized built-in gain carryover to 1997 of $10,400 ($20,000 - $9,600 = $10,400), consisting of $7,800 ($15,000 - $7,200 = $7,800) of recognized built-in ordinary income and $2,600 ($5,000 - $2,400 = $2,600) of recognized built-in capital gain.

SECTION 1.1374-3 NET UNREALIZED BUILT-IN GAIN.

(a) IN GENERAL. An S corporation's net unrealized built-in gain is the total of the following --

(1) The amount that would be the amount realized if, at the beginning of the first day of the recognition period, the corporation had remained a C corporation and had sold all its assets at fair market value to an unrelated party that assumed all its liabilities; decreased by

(2) Any liability of the corporation that would be included in the amount realized on the sale referred to in paragraph (a)(1) of this section, but only if the corporation would be allowed a deduction on payment of the liability; decreased by

(3) The aggregate adjusted bases of the corporation's assets at the time of the sale referred to in paragraph (a)(1) of this section; increased or decreased by

(4) The corporation's section 481 adjustments that would be taken into account on the sale referred to in paragraph (a)(1) of this section; and increased by

(5) Any recognized built-in loss that would not be allowed as a deduction under section 382, 383, or 384 on the sale referred to in paragraph (a)(1) of this section.

(b) EXAMPLE. The rules of this section are illustrated by the following example.

EXAMPLE. NET UNREALIZED BUILT-IN GAIN. (i) (a) X, a calendar year C corporation using the cash method, elects to become an S corporation on January 1, 1996. On December 31, 1995, X has assets and liabilities as follows:

 Assets                     FMV                Basis

(ii) If, on December 31, 1995, X sold all its assets to a third party that assumed all its liabilities, X's amount realized would be $1,050,000 ($750,000 cash received + $300,000 liabilities assumed = $1,050,000). Thus, X's net unrealized built-in gain is determined as follows:

 Amount realized             $1,050,000

(a) SALES AND EXCHANGES -- (1) IN GENERAL. Section 1374(d)(3) or 1374(d)(4) applies to any gain or loss recognized during the recognition period in a transaction treated as a sale or exchange for federal income tax purposes.

(2) Oil and gas property. For purposes of paragraph (a)(1) of this section, an S corporation's adjusted basis in oil and gas property equals the sum of the shareholders' adjusted bases in the property as determined in section 613A(c)(11)(B).

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

EXAMPLE 1. PRODUCTION AND SALE OF OIL. X is a C corporation that purchased a working interest in an oil and gas property for $100,000 on July 1, 1993. X elects to become an S corporation effective January 1, 1996. On that date, the working interest has a fair market value of $250,000 and an adjusted basis of $50,000, but no oil has as yet been extracted. In 1996, X begins production of the working interest, sells oil that it has produced to a refinery for $75,000, and includes that amount in gross income. Under paragraph (a)(1) of this section, the $75,000 is not recognized built-in gain because as of the beginning of the recognition period X held only a working interest in the oil and gas property (since the oil had not yet been extracted from the ground), and not the oil itself.

EXAMPLE 2. SALE OF OIL AND GAS PROPERTY. Y is a C corporation that elects to become an S corporation effective January 1, 1996. Y has two shareholders, A and B. A and B each own 50 percent of Y's stock. In addition, Y owns a royalty interest in an oil and gas property with a fair market value of $300,000 and an adjusted basis of $200,000. Under section 613A(c)(11)(B), Y's $200,000 adjusted basis in the royalty interest is allocated $100,000 to A and $100,000 to B. During 1996, A and B take depletion deductions with respect to the royalty interest of $10,000 and $15,000, respectively. As of January 1, 1997, A and B have a basis in the royalty interest of $90,000 and $85,000, respectively. On January 1, 1997, Y sells the royalty interest for $250,000. Under paragraph (a)(1) of this section, Y has gain recognized and recognized built-in gain of $75,000 ($250,000 - ($90,000 + $85,000) = $75,000) on the sale.

(b) ACCRUAL METHOD RULE -- (1) INCOME ITEMS. Except as otherwise provided in this section, any item of income properly taken into account during the recognition period is recognized built-in gain if the item would have been properly included in gross income before the beginning of the recognition period by an accrual method taxpayer (disregarding any method of accounting for which an election by the taxpayer must be made unless the taxpayer actually used the method when it was a C corporation).

(2) DEDUCTION ITEMS. Except as otherwise provided in this section, any item of deduction properly taken into account during the recognition period is recognized built-in loss if the item would have been properly allowed as a deduction against gross income before the beginning of the recognition period to an accrual method taxpayer (disregarding any method of accounting for which an election by the taxpayer must be made unless the taxpayer actually used the method when it was a C corporation). In determining whether an item would have been properly allowed as a deduction against gross income by an accrual method taxpayer for purposes of this paragraph, section 461(h)(2)(C) and section 1.461-4(g) (relating to liabilities for tort, worker's compensation, breach of contract, violation of law, rebates, refunds, awards, prizes, jackpots, insurance contracts, warranty contracts, service contracts, taxes, and other liabilities) do not apply.

(3) EXAMPLES. The rules of this paragraph (b) are illustrated by the following examples.

EXAMPLE 1. Accounts receivable. X is a C corporation using the cash method that elects to become an S corporation effective January 1, 1996. On January 1, 1996, X has $50,000 of accounts receivable for services rendered before that date. On that date, the accounts receivable have a fair market value of $40,000 and an adjusted basis of $0. In 1996, X collects $50,000 on the accounts receivable and includes that amount in gross income. Under paragraph (b)(1) of this section, the $50,000 included in gross income in 1996 is recognized built-in gain because it would have been included in gross income before the beginning of the recognition period if X had been an accrual method taxpayer. However, if X instead disposes of the accounts receivable for $45,000 on July 1, 1996, in a transaction treated as a sale or exchange for federal income tax purposes, X would have recognized built-in gain of $40,000 on the disposition.

EXAMPLE 2. CONTINGENT LIABILITY. Y is a C corporation using the cash method that elects to become an S corporation effective January 1, 1996. In 1995, a lawsuit was filed against Y claiming $1,000,000 in damages. In 1996, Y loses the lawsuit, pays a $500,000 judgment, and properly claims a deduction for that amount. Under paragraph (b)(2) of this section, the $500,000 deduction allowed in 1996 is not recognized built-in loss because it would not have been allowed as a deduction against gross income before the beginning of the recognition period if Y had been an accrual method taxpayer (even disregarding section 461(h)(2)(C) and section 1.461-4(g)).

EXAMPLE 3. DEFERRED PAYMENT LIABILITIES. X is a C corporation using the cash method that elects to become an S corporation on January 1, 1996. In 1995, X lost a lawsuit and became obligated to pay $150,000 in damages. Under section 461(h)(2)(C), this amount is not allowed as a deduction until X makes payment. In 1996, X makes payment and properly claims a deduction for the amount of the payment. Under paragraph (b)(2) of this section, the $150,000 deduction allowed in 1996 is recognized built-in loss because it would have been allowed as a deduction against gross income before the beginning of the recognition period if X had been an accrual method taxpayer (disregarding section 461(h)(2)(C) and section 1.461-4(g)).

EXAMPLE 4. DEFERRED PREPAYMENT INCOME. Y is a C corporation using an accrual method that elects to become an S corporation effective January 1, 1996. In 1995, Y received $2,500 for services to be rendered in 1996, and properly elected to include the $2,500 in gross income in 1996 under Rev. Proc. 71-21, 1971-2 C.B. 549 (see section 601.601(d)(2)(ii)(b) of this chapter). Under paragraph (b)(1) of this section, the $2,500 included in gross income in 1996 is not recognized built-in gain because it would not have been included in gross income before the beginning of the recognition period by an accrual method taxpayer using the method that Y actually used before the beginning of the recognition period.

EXAMPLE 5. CHANGE IN METHOD. X is a C corporation using an accrual method that elects to become an S corporation effective January 1, 1996. In 1995, X received $5,000 for services to be rendered in 1996, and properly included the $5,000 in gross income. In 1996, X properly elects to include the $5,000 in gross income in 1996 under Rev. Proc. 71-21, 1971-2 C.B. 549 (see section 601.601(d)(2)(ii)(b) of this chapter). As a result of the change in method of accounting, X has a $5,000 negative section 481(a) adjustment. Under paragraph (b)(1) of this section, the $5,000 included in gross income in 1996 is recognized built-in gain because it would have been included in gross income before the beginning of the recognition period by an accrual method taxpayer using the method that X actually used before the beginning of the recognition period. In addition, the $5,000 negative section 481(a) adjustment is recognized built-in loss because it relates to an item (the $5,000 X received for services in 1995) attributable to periods before the beginning of the recognition period under the principles for determining recognized built-in gain or loss in this section. See paragraph (d) of this section for rules regarding section 481(a) adjustments.

(c) SECTION 267(a)(2) AND 404(a)(5) DEDUCTIONS -- (1) SECTION 267(a)(2). Notwithstanding paragraph (b)(2) of this section, any amount properly deducted in the recognition period under section 267(a)(2), relating to payments to related parties, is recognized built-in loss to the extent--

(i) All events have occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability can be determined, as of the beginning of the recognition period; and

(ii) The amount is paid --

(A) In the first two and one-half months of the recognition period; or

(B) To a related party owning, under the attribution rules of section 267, less than 5 percent, by voting power and value, of the corporation's stock, both as of the beginning of the recognition period and when the amount is paid.

(2) SECTION 404(a)(5). Notwithstanding paragraph (b)(2) of this section, any amount properly deducted in the recognition period under section 404(a)(5), relating to payments for deferred compensation, is recognized built-in loss to the extent --

(i) All events have occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability can be determined, as of the beginning of the recognition period; and

(ii) The amount is not paid to a related party to which section 267(a)(2) applies.

(3) EXAMPLES. The rules of this paragraph (c) are illustrated by the following examples.

EXAMPLE 1. FIXED ANNUITY. X is a C corporation that elects to become an S corporation effective January 1, 1996. On December 31, 1995, A is age 60, has provided services to X as an employee for 20 years, and is a vested participant in X's unfunded nonqualified retirement plan. Under the plan, A receives $1,000 per month upon retirement until death. The plan provides no additional benefits. A retires on December 31, 1997, after working for X for 22 years. A at no time is a shareholder of X. X's deductions under section 404(a)(5) in the recognition period on paying A the $1,000 per month are recognized built-in loss because all events have occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability can be determined, as of the beginning of the recognition period.

EXAMPLE 2. INCREASE IN ANNUITY FOR WORKING BEYOND 20 YEARS. The facts are the same as Example 1, except that under the plan A receives $1,000 per month, plus $100 per month for each year A works for X beyond 20 years, upon retirement until death. X's deductions on paying A the $1,000 per month are recognized built-in loss. However, X's deductions on paying A the $200 per month for the two years A worked for X beyond 20 years are not recognized built-in loss because all events have not occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability cannot be determined, as of the beginning of the recognition period.

EXAMPLE 3. COST OF LIVING ADJUSTMENT. The facts are the same as Example 1, except that under the plan A receives $1,000 per month, plus annual cost of living adjustments, upon retirement until death. X's deductions under section 404(a)(5) on paying A the $1,000 per month are recognized built-in loss. However, X's deductions under section 404(a)(5) on paying A the annual cost of living adjustment are not recognized built-in loss because all events have not occurred that establish the fact of the liability to pay the amount, and the exact amount of the liability cannot be determined, as of the beginning of the recognition period.

(d) SECTION 481(a) ADJUSTMENTS -- (1) IN GENERAL. Any section 481(a) adjustment taken into account in the recognition period is recognized built-in gain or loss to the extent the adjustment relates to items attributable to periods before the beginning of the recognition period under the principles for determining recognized built-in gain or loss in this section. The principles for determining recognized built-in gain or loss in this section include, for example, the accrual method rule under paragraph (b) of this section.

(2) EXAMPLES. The rules of this paragraph (d) are illustrated by the following examples.

EXAMPLE 1. OMITTED ITEM ATTRIBUTABLE TO PRE-RECOGNITION PERIOD. X is a C corporation that elects to become an S corporation effective January 1, 1996. X improperly capitalizes repair costs and recovers the costs through depreciation of the related assets. In 1999, X properly changes to deducting repair costs as they are incurred. Under section 481(a), the basis of the related assets are reduced by an amount equal to the excess of the repair costs incurred before the year of change over the repair costs recovered through depreciation before the year of change. In addition, X has a negative section 481(a) adjustment equal to the basis reduction. Under paragraph (d)(1) of this section, the portion of X's negative section 481(a) adjustment relating to the repair costs incurred before the recognition period is recognized built-in loss because those repair costs are items attributable to periods before the beginning of the recognition period under the principles for determining recognized built-in gain or loss in this section.

EXAMPLE 2. DUPLICATED ITEM ATTRIBUTABLE TO PRE-RECOGNITION PERIOD. Y is a C corporation that elects to become an S corporation effective January 1, 1996. Y improperly uses an accrual method without regard to the economic performance rules of section 461(h) to account for worker's compensation claims. As a result, Y takes deductions when claims are filed. In 1999, Y properly changes to an accrual method with regard to the economic performance rules under section 461(h)(2)(C) for worker's compensation claims. As a result, Y takes deductions when claims are paid. The positive section 481(a) adjustment resulting from the change is equal to the amount of claims filed, but unpaid, before the year of change. Under paragraph (b)(2) of this section, the deduction allowed in the recognition period for claims filed, but unpaid, before the recognition period is recognized built-in loss because a deduction was allowed for those claims before the recognition period under an accrual method without regard to section 461(h)(2)(C). Under paragraph (d)(1) of this section, the portion of Y's positive section 481(a) adjustment relating to claims filed, but unpaid, before the recognition period is recognized built-in gain because those claims are items attributable to periods before the beginning of the recognition period under the principles for determining recognized built-in gain or loss in this section.

(e) SECTION 995(b)(2) DEEMED DISTRIBUTIONS. Any item of income properly taken into account during the recognition period under section 995(b)(2) is recognized built-in gain if the item results from a DISC termination or disqualification occurring before the beginning of the recognition period.

(f) DISCHARGE OF INDEBTEDNESS AND BAD DEBTS. Any item of income or deduction properly taken into account during the first year of the recognition period as discharge of indebtedness income under section 61(a)(12) or as a bad debt deduction under section 166 is recognized built-in gain or loss if the item arises from a debt owed by or to an S corporation at the beginning of the recognition period.

(g) COMPLETION OF CONTRACT. Any item of income properly taken into account during the recognition period under the completed contract method (as described in section 1.451-3(d)) where the corporation began performance of the contract before the beginning of the recognition period is recognized built-in gain if the item would have been included in gross income before the beginning of the recognition period under the percentage of completion method (as described in section 1.451-3(c)). Any similar item of deduction is recognized built-in loss if the item would have been allowed as a deduction against gross income before the beginning of the recognition period under the percentage of completion method.

(h) INSTALLMENT METHOD -- (1) IN GENERAL. If a corporation sells an asset before or during the recognition period and reports the income from the sale using the installment method under section 453 during or after the recognition period, that income is subject to tax under section 1374.

(2) LIMITATION ON AMOUNT SUBJECT TO TAX. For purposes of paragraph (h)(1) of this section, the taxable income limitation under section 1.1374-2(a)(2) is equal to the amount by which the S corporation's net recognized built-in gain would have been increased from the year of the sale to the earlier of the year the income is reported under the installment method or the last year of the recognition period, assuming all income from the sale had been reported in the year of the sale and all provisions of section 1374 applied. For purposes of the preceding sentence, if the corporation sells the asset before the recognition period, the income from the sale that is not reported before the recognition period is treated as having been reported in the first year of the recognition period.

(3) ROLLOVER RULE. If the limitation in paragraph (h)(2) of this section applies, the excess of the amount reported under the installment method over the amount subject to tax under the limitation is treated as if it were reported in the succeeding taxable year(s), but only for succeeding taxable year(s) in the recognition period. The amount reported in the succeeding taxable year(s) under the preceding sentence is reduced to the extent that the amount not subject to tax under the limitation in paragraph (h)(2) of this section was not subject to tax because the S corporation had an excess of recognized built-in loss over recognized built-in gain in the taxable year of the sale and succeeding taxable year(s) in the recognition period.

(4) USE OF LOSSES AND SECTION 1374 ATTRIBUTES. If income is reported under the installment method by an S corporation for a taxable year after the recognition period and the income is subject to tax under paragraph (h)(1) of this section, the S corporation's section 1374 attributes may be used to the extent their use is allowed under all applicable provisions of the Code in determining the section 1374 tax. However, the S corporation's loss recognized for a taxable year after the recognition period that would have been recognized built-in loss if it had been recognized in the recognition period may not be used in determining the section 1374 tax.

(5) EXAMPLES. The rules of this paragraph (h) are illustrated by the following examples.

EXAMPLE 1. ROLLOVER RULE. X is a C corporation that elects to become an S corporation effective January 1, 1996. On that date, X sells Blackacre with a basis of $0 and a value of $100,000 in exchange for a $100,000 note bearing a market rate of interest payable on January 1, 2001. X does not make the election under section 453(d) and, therefore, reports the $100,000 gain using the installment method under section 453. In the year 2001, X has income of $100,000 on collecting the note, unexpired C year attributes of $0, recognized built-in loss of $0, current losses of $100,000, and taxable income of $0. If X had reported the $100,000 gain in 1996, X's net recognized built-in gain from 1996 through 2001 would have been $75,000 greater than otherwise. Under paragraph (h) of this section, X has $75,000 net recognized built-in gain subject to tax under section 1374. X also must treat the $25,000 excess of the amount reported, $100,000, over the amount subject to tax, $75,000, as income reported under the installment method in the succeeding taxable year(s) in the recognition period, except to the extent X establishes that the $25,000 was not subject to tax under section 1374 in the year 2001 because X had an excess of recognized built-in loss over recognized built-in gain in the taxable year of the sale and succeeding taxable year(s) in the recognition period.

EXAMPLE 2. USE OF LOSSES. Y is a C corporation that elects to become an S corporation effective January 1, 1996. On that date, Y sells Whiteacre with a basis of $0 and a value of $250,000 in exchange for a $250,000 note bearing a market rate of interest payable on January 1, 2006. Y does not make the election under section 453(d) and, therefore, reports the $250,000 gain using the installment method under section 453. In the year 2006, Y has income of $250,000 on collecting the note, unexpired C year attributes of $0, loss of $100,000 that would have been recognized built-in loss if it had been recognized in the recognition period, current losses of $150,000, and taxable income of $0. If Y had reported the $250,000 gain in 1996, X's net recognized built-in gain from 1996 through 2005 (that is, during the recognition period) would have been $225,000 greater than otherwise. Under paragraph (h) of this section, X has $225,000 net recognized built-in gain subject to tax under section 1374.

EXAMPLE 3. USE OF SECTION 1374 ATTRIBUTE. Z is a C corporation that elects to become an S corporation effective January 1, 1996. On that date, Z sells Greenacre with a basis of $0 and a value of $500,000 in exchange for a $500,000 note bearing a market rate of interest payable on January 1, 2011. Z does not make the election under section 453(d) and, therefore, reports the $500,000 gain using the installment method under section 453. In the year 2011, Z has income of $500,000 on collecting the note, loss of $0 that would have been recognized built-in loss if it had been recognized in the recognition period, current losses of $0, taxable income of $500,000, and a minimum tax credit of $60,000 arising in 1995. None of Z's minimum tax credit is limited under sections 53(c) or 383. If Z had reported the $500,000 gain in 1996, Z's net recognized built-in gain from 1996 through 2005 (that is, during the recognition period) would have been $350,000 greater than otherwise. Under paragraph (h) of this section, Z has $350,000 net recognized built-in gain subject to tax under section 1374, a tentative section 1374 tax of $122,500 ($350,000 x .35 = $122,500), and a section 1374 tax after using its minimum tax credit arising in 1995 of $62,250 ($122,500 - $60,000 = $62,250).

(i) PARTNERSHIP INTERESTS -- (1) IN GENERAL. If an S corporation owns a partnership interest at the beginning of the recognition period or transfers property to a partnership in a transaction to which section 1374(d)(6) applies during the recognition period, the S corporation determines the effect on net recognized built-in gain from its distributive share of partnership items as follows--

(i) Step One: Apply the rules of section 1374(d) to the S corporation's distributive share of partnership items of income, gain, loss, or deduction included in income or allowed as a deduction under the rules of subchapter K to determine the extent to which it would have been treated as recognized built-in gain or loss if the partnership items had originated in and been taken into account directly by the S corporation (partnership 1374 items);

(ii) Step Two: Determine the S corporation's net recognized built-in gain without partnership 1374 items;

(iii) Step Three: Determine the S corporation's net recognized built-in gain with partnership 1374 items; and

(iv) Step Four: If the amount computed under Step Three (paragraph (i)(1)(iii) of this section) exceeds the amount computed under Step Two (paragraph (i)(1)(ii) of this section), the excess (as limited by paragraph (i)(2)(i) of this section) is the S corporation's partnership RBIG, and the S corporation's net recognized built-in gain is the sum of the amount computed under Step Two (paragraph (i)(1)(ii) of this section) plus the partnership RBIG. If the amount computed under Step Two (paragraph (i)(1)(ii) of this section) exceeds the amount computed under Step Three (paragraph (i)(1)(iii) of this section), the excess (as limited by paragraph (i)(2)(ii) of this section) is the S corporation's partnership RBIL, and the S corporation's net recognized built-in gain is the remainder of the amount computed under Step Two (paragraph (i)(1)(ii) of this section) after subtracting the partnership RBIL.

(2) LIMITATIONS -- (i) PARTNERSHIP RBIG. An S corporation's partnership RBIG for any taxable year may not exceed the excess (if any) of the S corporation's RBIG limitation over its partnership RBIG for prior taxable years. The preceding sentence does not apply if a corporation forms or avails of a partnership with a principal purpose of avoiding the tax imposed under section 1374.

(ii) PARTNERSHIP RBIL. An S corporation's partnership RBIL for any taxable year may not exceed the excess (if any) of the S corporation's RBIL limitation over its partnership RBIL for prior taxable years.

(3) DISPOSITION OF PARTNERSHIP INTEREST. If an S corporation disposes of its partnership interest, the amount that may be treated as recognized built-in gain may not exceed the excess (if any) of the S corporation's RBIG limitation over its partnership RBIG during the recognition period. Similarly, the amount that may be treated as recognized built-in loss may not exceed the excess (if any) of the S corporation's RBIL limitation over its partnership RBIL during the recognition period.

(4) RBIG AND RBIL LIMITATIONS -- (i) SALE OF PARTNERSHIP INTEREST. An S corporation's RBIG or RBIL limitation is the total of the following --

(A) The amount that would be the amount realized if, at the beginning of the first day of the recognition period, the corporation had remained a C corporation and had sold its partnership interest (and any assets the corporation contributed to the partnership during the recognition period) at fair market value to an unrelated party; decreased by

(B) The corporation's adjusted basis in the partnership interest (and any assets the corporation contributed to the partnership during the recognition period) at the time of the sale referred to in paragraph (i)(4)(i)(A) of this section; and increased or decreased by

(C) The corporation's allocable share of the partnership's section 481(a) adjustments at the time of the sale referred to in paragraph (i)(4)(i)(A) of this section.

(ii) AMOUNTS OF LIMITATIONS. If the result in paragraph (i)(4)(i) of this section is a positive amount, the S corporation has a RBIG limitation equal to that amount and a RBIL limitation of $0, but if the result in paragraph (i)(4)(i) of this section is a negative amount, the S corporation has a RBIL limitation equal to that amount and a RBIG limitation of $0.

(5) SMALL INTEREST EXCEPTION -- (i) IN GENERAL. Paragraph (i)(1) of this section does not apply to a taxable year in the recognition period if the S corporation's partnership interest represents less than 10 percent of the partnership's capital and profits at all times during the taxable year and prior taxable years in the recognition period, and the fair market value of the S corporation's partnership interest as of the beginning of the recognition period is less than $100,000.

(ii) CONTRIBUTED ASSETS. For purposes of paragraph (i)(5)(i) of this section, if the S corporation contributes any assets to the partnership during the recognition period and the S corporation held the assets as of the beginning of the recognition period, the fair market value of the S corporation's partnership interest as of the beginning of the recognition period is determined as if the assets were contributed to the partnership before the beginning of the recognition period (using the fair market value of each contributed asset as of the beginning of the recognition period). The contribution does not affect whether paragraph (i)(5)(i) of this section applies for taxable years in the recognition period before the taxable year in which the contribution was made.

(iii) ANTI-ABUSE RULE. Paragraph (i)(5)(i) of this section does not apply if a corporation forms or avails of a partnership with a principal purpose of avoiding the tax imposed under section 1374.

(6) SECTION 704(c) GAIN OR LOSS. Solely for purposes of section 1374, an S corporation's section 704(c) gain or loss amount with respect to any asset is not reduced during the recognition period, except for amounts treated as recognized built-in gain or loss with respect to that asset under this paragraph.

(7) DISPOSITION OF DISTRIBUTED PARTNERSHIP ASSET. If on the first day of the recognition period an S corporation holds an interest in a partnership that holds an asset and during the recognition period the partnership distributes the asset to the S corporation that thereafter disposes of the asset, the asset is treated as having been held by the S corporation on the first day of the recognition period and as having the fair market value and adjusted basis in the hands of the S corporation that it had in the hands of the partnership on that day.

(8) EXAMPLES. The rules of this paragraph (i) are illustrated by the following examples.

EXAMPLE 1. PRE-CONVERSION PARTNERSHIP INTEREST. X is a C corporation that elects to become an S corporation on January 1, 1996. On that date, X owns a 50 percent interest in partnership P and P owns (among other assets) Blackacre with a basis of $25,000 and a value of $45,000. In 1996, P buys Whiteacre for $50,000. In 1999, P sells Blackacre for $55,000 and recognizes a gain of $30,000 of which $15,000 is included in X's distributive share. P also sells Whiteacre in 1999 for $42,000 and recognizes a loss of $8,000 of which $4,000 is included in X's distributive share. Under this paragraph and section 1374(d)(3), X's $15,000 gain is presumed to be recognized built- in gain and thus treated as a partnership 1374 item, but this presumption is rebutted if X establishes that P's gain would have been only $20,000 ($45,000 -$25,000 = $20,000) if Blackacre had been sold on the first day of the recognition period. In such a case, only X's distributive share of the $20,000 built-in gain, $10,000, would be treated as a partnership 1374 item. Under this paragraph and section 1374(d)(4), X's $4,000 loss is not treated as a partnership 1374 item because P did not hold Whiteacre on the first day of the recognition period.

EXAMPLE 2. POST-CONVERSION CONTRIBUTION. Y is a C corporation that elects to become an S corporation on January 1, 1996. On that date, Y owns (among other assets) Blackacre with a basis of $100,000 and a value of $200,000. On January 1, 1998, when Blackacre has a basis of $100,000 and a value of $200,000, Y contributes Blackacre to partnership P for a 50 percent interest in P. On January 1, 2000, P sells Blackacre for $300,000 and recognizes a gain of $200,000 on the sale ($300,000 - $100,000 = $200,000). P is allocated $100,000 of the gain under section 704(c), and another $50,000 of the gain for its fifty percent share of the remainder, for a total of $150,000. Under this paragraph and section 1374(d)(3), if Y establishes that P's gain would have been only $100,000 ($200,000 - $100,000 = $100,000) if Blackacre had been sold on the first day of the recognition period, Y would treat only $100,000 as a partnership 1374 item.

EXAMPLE 3. RBIG LIMITATION OF $100,000 OR $50,000. X is a C corporation that elects to become an S corporation on January 1, 1996. On that date, X owns a 50 percent interest in partnership P with a RBIG limitation of $100,000 and a RBIL limitation of $0. P owns (among other assets) Blackacre with a basis of $50,000 and a value of $200,000. In 1996, P sells Blackacre for $200,000 and recognizes a gain of $150,000 of which $75,000 is included in X's distributive share and treated as a partnership 1374 item. X's net recognized built-in gain for 1996 computed without partnership 1374 items is $35,000 and with partnership 1374 items is $110,000. Thus, X has a partnership RBIG of $75,000 except as limited under paragraph (i)(2)(i) of this section. Because X's RBIG limitation is $100,000, X's partnership RBIG of $75,000 is not limited and X's net recognized built-in gain for the year is $110,000 ($35,000 + $75,000 = $110,000). However, if X had a RBIG limitation of $50,000 instead of $100,000, X's partnership RBIG would be limited to $50,000 under paragraph (i)(2)(i) of this section and X's net recognized built-in gain would be $85,000 ($35,000 + $50,000 = $85,000).

EXAMPLE 4. RBIL LIMITATION OF $60,000 OR $40,000. Y is a C corporation that elects to become an S corporation on January 1, 1996. On that date, Y owns a 50 percent interest in partnership P with a RBIG limitation of $0 and a RBIL limitation of $60,000. P owns (among other assets) Blackacre with a basis of $225,000 and a value of $125,000. In 1996, P sells Blackacre for $125,000 and recognizes a loss of $100,000 of which $50,000 is included in Y's distributive share and treated as a partnership 1374 item. Y's net recognized built-in gain for 1996 computed without partnership 1374 items is $75,000 and with partnership 1374 items is $25,000. Thus, Y has a partnership RBIL of $50,000 for the year except as limited under paragraph (i)(2)(ii) of this section. Because Y's RBIL limitation is $60,000, Y's partnership RBIL for the year is not limited and Y's net recognized built-in gain for the year is $25,000 ($75,000 - $50,000 = $25,000). However, if Y had a RBIL limitation of $40,000 instead of $60,000, Y's partnership RBIL would be limited to $40,000 under paragraph (i)(2)(ii) of this section and Y's net recognized built-in gain for the year would be $35,000 ($75,000 - $40,000 = $35,000).

EXAMPLE 5. RBIG LIMITATION OF $0. (i) X is a C corporation that elects to become an S corporation on January 1, 1996. X owns a 50 percent interest in partnership P with a RBIG limitation of $0 and a RBIL limitation of $25,000.

(a) In 1996, P's partnership 1374 items are --

(1) Ordinary income of $25,000; and

(2) Capital gain of $75,000.

(b) X itself has --

(1) Recognized built-in ordinary income of $40,000; and

(2) Recognized built-in capital loss of $90,000.

(ii) X's net recognized built-in gain for 1996 computed without partnership 1374 items is $40,000 and with partnership 1374 items is $65,000 ($40,000 + $25,000 = $65,000). Thus, X's partnership RBIG is $25,000 for the year except as limited under paragraph (i)(2)(i) of this section. Because X's RBIG limitation is $0, X's partnership RBIG of $25,000 is limited to $0 and X's net recognized built-in gain for the year is $40,000.

EXAMPLE 6. RBIL LIMITATION OF $0. (i) Y is a C corporation that elects to become an S corporation on January 1, 1996. Y owns a 50 percent interest in partnership P with a RBIG limitation of $60,000 and a RBIL limitation of $0.

(a) In 1996, P's partnership 1374 items are --

(1) Ordinary income of $25,000; and

(2) Capital loss of $90,000.

(b) Y itself has --

(1) recognized built-in ordinary income of $40,000; and

(2) recognized built-in capital gain of $75,000.

(ii) Y's net recognized built-in gain for 1996 computed without partnership 1374 items is $115,000 ($40,000 + $75,000 = $115,000) and with partnership 1374 items is $65,000 ($40,000 + $25,000 = $65,000). Thus, Y's partnership RBIL is $50,000 for the year except as limited under paragraph (i)(2)(ii) of this section. Because Y's RBIL limitation is $0, Y's partnership RBIL of $50,000 is limited to $0 and Y's net recognized built-in gain is $115,000.

EXAMPLE 7. DISPOSITION OF PARTNERSHIP INTEREST. X is a C corporation that elects to become an S corporation on January 1, 1996. On that date, X owns a 50 percent interest in partnership P with a RBIG limitation of $200,000 and a RBIL limitation of $0. P owns (among other assets) Blackacre with a basis of $20,000 and a value of $140,000. In 1996, P sells Blackacre for $140,000 and recognizes a gain of $120,000 of which $60,000 is included in X's distributive share and treated as a partnership 1374 item. X's net recognized built-in gain for 1996 computed without partnership 1374 items is $95,000 and with partnership 1374 items is $155,000. Thus, X has a partnership RBIG of $60,000. In 1999, X sells its entire interest in P for $350,000 and recognizes a gain of $250,000. Under paragraph (i)(3) of this section, X's recognized built-in gain on the sale is limited by its RBIG limitation to $140,000 ($200,000 - $60,000 = $140,000).

EXAMPLE 8. SECTION 704(c) CASE. Y is a C corporation that elects to become an S corporation on January 1, 1996. On that date, Y contributes Asset 1, 5-year property with a value of $40,000 and a basis of $0, and an unrelated party contributes $40,000 in cash, each for a 50 percent interest in partnership P. The partnership adopts the traditional method under section 1.704-3(b). If P sold Asset 1 for $40,000 immediately after it was contributed by Y, P's $40,000 gain would be allocated to Y under section 704(c). Instead, Asset 1 is sold by P in 1999 for $36,000 and P recognizes gain of $36,000 ($36,000 - $0 = $36,000) on the sale. However, because book depreciation of $8,000 per year has been taken on Asset 1 in 1996, 1997, and 1998, Y is allocated only $16,000 of P's $36,000 gain ($40,000 - (3 x $8,000) = ($16,000 - $0) = $16,000) under section 704(c). The remaining $20,000 of P's $36,000 gain ($36,000 - $16,000 = $20,000) is allocated 50 percent to each partner under section 704(b). Thus, a total of $26,000 ($16,000 + $10,000 = $26,000) of P's $36,000 gain is allocated to Y. However, under paragraph (i)(6) of this section, Y treats $36,000 as a partnership 1374 item on P's sale of Asset 1.

EXAMPLE 9. DISPOSITION OF DISTRIBUTED PARTNERSHIP ASSET. X is a C corporation that elects to become an S corporation on January 1, 1996. On that date, X owns a fifty percent interest in partnership P and P owns (among other assets) Blackacre with a basis of $20,000 and a value of $40,000. On January 1, 1998, P distributes Blackacre to X, when Blackacre has a basis of $20,000 and a value of $50,000. Under section 732(a)(1), X has a transferred basis of $20,000 in Blackacre. On January 1, 1999, X sells Blackacre for $60,000 and recognizes a gain of $40,000. Under paragraph (i)(7) of this section and section 1374(d)(3), X has recognized built-in gain from the sale of $20,000, the amount of built-in gain in Blackacre on the first day of the recognition period.

SECTION 1.1374-5 LOSS CARRYFORWARDS.

(a) IN GENERAL. The loss carryforwards allowed as deductions against net recognized built-in gain under section 1374(b)(2) are allowed only to the extent their use is allowed under the rules applying to C corporations. Any other loss carryforwards, such as charitable contribution carryforwards under section 170(d)(2), are not allowed as deductions against net recognized built-in gain.

(b) EXAMPLE. The rules of this section are illustrated by the following example.

EXAMPLE. SECTION 382 LIMITATION. X is a C corporation that has an ownership change under section 382(g)(1) on January 1, 1994. On that date, X has a fair market value of $500,000, NOL carryforwards of $400,000, and a net unrealized built-in gain under section 382(h)(3)(A) of $0. Assume X's section 382 limitation under section 382(b)(1) is $40,000. X elects to become an S corporation on January 1, 1998. On that date, X has NOL carryforwards of $240,000 (having used $160,000 of its pre- change net operating losses in its 4 preceding taxable years) and a section 1374 net unrealized built-in gain of $250,000. In 1998, X has net recognized built-in gain of $100,000. X may use $40,000 of its NOL carryforwards as a deduction against its $100,000 net recognized built-in gain, because X's section 382 limitation is $40,000.

SECTION 1.1374-6 CREDITS AND CREDIT CARRYFORWARDS.

(a) IN GENERAL. The credits and credit carryforwards allowed as credits against the section 1374 tax under section 1374(b)(3) are allowed only to the extent their use is allowed under the rules applying to C corporations. Any other credits or credit carryforwards, such as foreign tax credits under section 901, are not allowed as credits against the section 1374 tax.

(b) LIMITATIONS. The amount of business credit carryforwards and minimum tax credit allowed against the section 1374 tax are subject to the limitations described in section 38(c) and section 53(c), respectively, as modified by this paragraph. The tentative tax determined under paragraph (a)(3) of section 1.1374-1 is treated as the regular tax liability described in sections 38(c)(1) and 53(c)(1), and as the net income tax and net regular tax liability described in section 38(c)(1). The tentative minimum tax described in section 55(b) is determined using the rate of tax applicable to corporations and without regard to any alternative minimum tax foreign tax credit described in that section and by treating the net recognized built-in gain determined under section 1.1374-2, modified to take into account the adjustments of sections 56 and 58 applicable to corporations and the preferences of section 57, as the alternative minimum taxable income described in section 55(b)(2).

(c) EXAMPLES. The rules of this section are illustrated by the following examples.

EXAMPLE 1. BUSINESS CREDIT CARRYFORWARD. X is a C corporation that elects to become an S corporation effective January 1, 1996. On that date, X has a $500,000 business credit carryforward from a C year and Asset #1 with a fair market value of $400,000, a basis for regular tax purposes of $95,000, and a basis for alternative minimum tax purposes of $150,000. In 1996, X has net recognized built-in gain of $305,000 from selling Asset #1 for $400,000. Thus, X's tentative tax under paragraph (a)(3) of section 1.1374-1 and regular tax liability under paragraph (b) of this section is $106,750 ($400,000 - $95,000 = $305,000 x .35 = $106,750, assuming a 35 percent tax rate). Also, X's tentative minimum tax determined under paragraph (b) of this section is $47,000 [$400,000 - $150,000 = $250,000 - $15,000 ($40,000 corporate exemption amount - $25,000 phase-out = $15,000) = $235,000 x .20 = $47,000, assuming a 20 percent tax rate]. Thus, the business credit limitation under section 38(c) is $59,750 [$106,750 - $47,000 (the greater of $47,000 or $20,438 (.25 x $81,750 ($106,750 - $25,000 = $81,750))) = $59,750]. As a result, X's section 1374 tax is $47,000 ($106,750 - $59,750 = $47,000) for 1996 and X has $440,250 ($500,000 - $59,750 = $440,250) of business credit carryforwards for succeeding taxable years.

EXAMPLE 2. MINIMUM TAX CREDIT. Y is a C corporation that elects to become an S corporation effective January 1, 1996. On that date, Asset #1 has a fair market value of $5,000,000, a basis for regular tax purposes of $4,000,000, and a basis for alternative minimum tax purposes of $4,750,000. Y also has a minimum tax credit of $310,000 from 1995. Y has no other assets, no net operating or capital loss carryforwards, and no business credit carryforwards. In 1996, Y's only transaction is the sale of Asset #1 for $5,000,000. Therefore, Y has net recognized built-in gain in 1996 of $1,000,000 ($5,000,000 - $4,000,000 = $1,000,000) and a tentative tax under paragraph (a)(3) of section 1.1374-1 of $350,000 ($1,000,000 x .35 = $350,000, assuming a 35 percent tax rate). Also, Y's tentative minimum tax determined under paragraph (b) of this section is $47,000 [$5,000,000 - $4,750,000 = $250,000 - $15,000 ($40,000 corporate exemption amount - $25,000 phase-out = $15,000) = $235,000 x .20 = $47,000, assuming a 20 percent tax rate]. Thus, Y may use its minimum tax credit in the amount of $303,000 ($350,000 - $47,000 = $303,000) to offset its section 1374 tentative tax. As a result, Y's section 1374 tax is $47,000 ($350,000 - $303,000 = $47,000) in 1996 and Y has a minimum tax credit attributable to years for which Y was a C corporation of $7,000 ($310,000 - $303,000 = $7,000).

SECTION 1.1374-7 INVENTORY.

(a) VALUATION. The fair market value of the inventory of an S corporation on the first day of the recognition period equals the amount that a willing buyer would pay a willing seller for the inventory in a purchase of all the S corporation's assets by a buyer that expects to continue to operate the S corporation's business. For purposes of the preceding sentence, the buyer and seller are presumed not to be under any compulsion to buy or sell and to have reasonable knowledge of all relevant facts.

(b) IDENTITY OF DISPOSITIONS. The inventory method used by an S corporation for tax purposes must be used to identify whether the inventory it disposes of during the recognition period is inventory it held on the first day of that period. Thus, a corporation using the LIFO method does not dispose of inventory it held on the first day of the recognition period unless the carrying value of its inventory for a taxable year during that period is less than the carrying value of its inventory on the first day of the recognition period (determined using the LIFO method as described in section 472). However, if a corporation changes its method of accounting for inventory (for example, from the FIFO method to the LIFO method or from the LIFO method to the FIFO method) with a principal purpose of avoiding the tax imposed under section 1374, it must use its former method to identify its dispositions of inventory.

SECTION 1.1374-8 SECTION 1374(d)(8) TRANSACTIONS.

(a) IN GENERAL. If any S corporation acquires any asset in a transaction in which the S corporation's basis in the asset is determined (in whole or in part) by reference to a C corporation's basis in the assets (or any other property) (a section 1374(d)(8) transaction), section 1374 applies to the net recognized built-in gain attributable to the assets acquired in any section 1374(d)(8) transaction.

(b) SEPARATE DETERMINATION OF TAX. For purposes of the tax imposed under section 1374(d)(8), a separate determination of tax is made with respect to the assets the S corporation acquires in one section 1374(d)(8) transaction from the assets the S corporation acquires in another section 1374(d)(8) transaction and from the assets the corporation held when it became an S corporation. Thus, an S corporation's section 1374 attributes when it became an S corporation may only be used to reduce the section 1374 tax imposed on dispositions of assets the S corporation held at that time. Similarly, an S corporation's section 1374 attributes acquired in a section 1374(d)(8) transaction may only be used to reduce a section 1374 tax imposed on dispositions of assets the S corporation acquired in the same transaction.

(c) TAXABLE INCOME LIMITATION. For purposes of paragraph (a) of this section, an S corporation's taxable income limitation under section 1.1374-2(a)(2) for any taxable year is allocated between or among each of the S corporation's separate determinations of net recognized built-in gain for that year (determined without regard to the taxable income limitation) based on the ratio of each of those determinations to the sum of all of those determinations.

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

EXAMPLE 1. SEPARATE DETERMINATION OF TAX. (i) X is a C corporation that elected to become an S corporation effective January 1, 1986 (before section 1374 was amended in the Tax Reform Act of 1986). X has a net operating loss carryforward of $20,000 arising in 1985 when X was a C corporation. On January 1, 1996, Y (an unrelated C corporation) merges into X in a transaction to which section 368(a)(1)(A) applies. Y has no loss carryforwards, credits, or credit carryforwards. The assets X acquired from Y are subject to tax under section 1374 and have a net unrealized built-in gain of $150,000.

(ii) In 1996, X has a pre-limitation amount of $50,000 on dispositions of assets acquired from Y and a taxable income limitation of $100,000 (because only one group of assets is subject to section 1374, there is no allocation of the taxable income limitation). As a result, X has a net recognized built- in gain on those assets of $50,000. X's $20,000 net operating loss carryforward may not be used as a deduction against its $50,000 net recognized built-in gain on the assets X acquired from Y. Therefore, X has a section 1374 tax of $17,500 ($50,000 x .35 = $17,500, assuming a 35 percent tax rate) for its 1996 taxable year.

EXAMPLE 2. ALLOCATION OF TAXABLE INCOME LIMITATION. (i) Y is a C corporation that elects to become an S corporation effective January 1, 1996. The assets Y holds when it becomes an S corporation have a net unrealized built-in gain of $5,000. Y has no loss carryforwards, credits, or credit carryforwards. On January 1, 1997, Z (an unrelated C corporation) merges into Y in a transaction to which section 368(a)(1)(A) applies. Z has no loss carryforwards, credits, or credit carryforwards. The assets Y acquired from Z are subject to tax under section 1374 and have a net unrealized built-in gain of $80,000.

(ii) In 1997, Y has a pre-limitation amount on the assets it held when it became an S corporation of $15,000, a pre- limitation amount on the assets Y acquired from Z of $15,000, and a taxable income limitation of $10,000. However, because the assets Y held on becoming an S corporation have a net unrealized built-in gain of $5,000, its net recognized built-in gain on those assets is limited to $5,000 before taking into account the taxable income limitation. Y's taxable income limitation of $10,000 is allocated between the assets Y held on becoming an S corporation and the assets Y acquired from Z for purposes of determining the net recognized built-in gain from each pool of assets. Thus, Y's net recognized built-in gain on the assets Y held on becoming an S corporation is $2,500 [$10,000 x ($5,000/$20,000) = $2,500]. Y's net recognized built-in gain on the assets Y acquired from Z is $7,500 [$10,000 x ($15,000/$20,000) = $7,500]. Therefore, Y has a section 1374 tax of $3,500 [($2,500 + $7,500) x .35 = $3,500, assuming a 35 percent tax rate] for its 1997 taxable year.

SECTION 1.1374-9 ANTI-STUFFING RULE.

If a corporation acquires an asset before or during the recognition period with a principal purpose of avoiding the tax imposed under section 1374, the asset and any loss, deduction, loss carryforward, credit, or credit carryforward attributable to the asset is disregarded in determining the S corporation's pre- limitation amount, taxable income limitation, net unrealized built-in gain limitation, deductions against net recognized built-in gain, and credits against the section 1374 tax.

SECTION 1.1374-10 EFFECTIVE DATE AND ADDITIONAL RULES.

(a) IN GENERAL. Sections 1.1374-1 through 1.1374-9 apply for taxable years ending on or after [December 27, 1994], but only in cases where the S corporation's return for the taxable year is filed pursuant to an S election or a section 1374(d)(8) transaction occurring on or after December 27, 1994.

(b) ADDITIONAL RULES. This paragraph (b) provides rules applicable to certain S corporations, assets, or transactions to which sections 1.1374-1 through 1.1374-9 do not apply.

(1) CERTAIN TRANSFERS TO PARTNERSHIPS. If a corporation transfers an asset to a partnership in a transaction to which section 721(a) applies and the transfer is made in contemplation of an S election or during the recognition period, section 1374 applies on a disposition of the asset by the partnership as if the S corporation had disposed of the asset itself. This paragraph (b)(1) applies as of the effective date of section 1374, unless the recognition period with respect to the contributed asset is pursuant to an S election or a section 1374(d)(8) transaction occurring on or after December 27, 1994.

(2) CERTAIN INVENTORY DISPOSITIONS. For purposes of section 1374(d)(2)(A), the inventory method used by the taxpayer for tax purposes (FIFO, LIFO, etc.) must be used to identify whether goods disposed of following conversion to S corporation status were held by the corporation at the time of conversion. Thus, for example, a corporation using the LIFO inventory method will not be subject to the built-in gain tax with respect to sales of inventory except to the extent that a LIFO layer existing prior to the beginning of the first taxable year as an S corporation is invaded after the beginning of that year. This paragraph (b)(2) applies as of the effective date of section 1374, unless the recognition period with respect to the inventory is pursuant to an S election or a section 1374(d)(8) transaction occurring on or after December 27, 1994.

(3) CERTAIN CONTRIBUTIONS OF BUILT-IN LOSS ASSETS. If a built- in loss asset (that is, an asset with an adjusted tax basis in excess of its fair market value) is contributed to a corporation within 2 years before the earlier of the beginning of its first taxable year as an S corporation, or the filing of its S election, the loss inherent in the asset will not reduce net unrealized built-in gain, as defined in section 1374(d)(1), unless the taxpayer demonstrates a clear and substantial relationship between the contributed property and the conduct of the corporation's current or future business enterprises. This paragraph (b)(3) applies as of the effective date of section 1374, unless the recognition period with respect to the contributed asset is pursuant to an S election or a section 1374(d)(8) transaction occurring on or after December 27, 1994.

(4) CERTAIN INSTALLMENT SALES -- (i) IN GENERAL. If a taxpayer sells an asset either prior to or during the recognition period and recognizes income either during or after the recognition period from the sale under the installment method, the income will, when recognized, be taxed under section 1374 to the extent it would have been so taxed in prior taxable years if the selling corporation had made the election under section 453(d) not to report the income under the installment method. For purposes of determining the extent to which the income would have been subject to tax if the section 453(d) election had not been made, the taxable income limitation of section 1374(d)(2)(A)(ii) and the built-in gain carryover rule of section 1374(d)(2)(B) will be taken into account. This paragraph (b)(4) applies for installment sales occurring on or after March 26, 1990, and before December 27, 1994.

(ii) EXAMPLES. The rules of this paragraph (b)(4) are illustrated by the following examples.

EXAMPLE 1. In year 1 of the recognition period under section 1374, a corporation realizes a gain of $100,000 on the sale of an asset with built-in gain. The corporation is to receive full payment for the asset in year 11. Because the corporation does not make an election under section 453(d), all $100,000 of the gain from the sale is reported under the installment method in year 11. If the corporation had made an election under section 453(d) with respect to the sale, the gain would have been recognized in year 1 and, taking into account the corporation's income and gains from other sources, application of the taxable income limitation of section 1374(d)(2)(A)(ii) and the built-in gain carryover rule of section 1374(d)(2)(B) would have resulted in $40,000 of the gain being subject to tax during the recognition period under section 1374. Therefore, $40,000 of the gain recognized in year 11 is subject to tax under section 1374.

EXAMPLE 2. In year 1 of the recognition period under section 1374, a corporation realizes a gain of $100,000 on the sale of an asset with built-in gain. The corporation is to receive full payment for the asset in year 6. Because the corporation does not make an election under section 453(d), all $100,000 of the gain from the sale is reported under the installment method in year 6. If the corporation had made an election under section 453(d) with respect to the sale, the gain would have been recognized in year 1 and, taking into account the corporation's income and gains from other sources, application of the taxable income limitation of section 1374(d)(2)(A)(ii) and the built-in gain carryover rule of section 1374(d)(2)(B) would have resulted in all of the gain being subjected to tax under section 1374 in years 1 through 5. Therefore, notwithstanding that the taxable income limitation of section 1374(d)(2)(A)(ii) might otherwise limit the taxation of the gain recognized in year 6, the entire $100,000 of gain will be subject to tax under section 1374 when it is recognized in year 6.