Federal Register / Vol. 60, No. 245 / Thursday, December 21, 1995 / Proposed Rules 66237

in the same manner as if the deemed

distribution were an actual distribution.

(c) Section 4980A. For purposes of

section 4980A, a deemed distribution

under section 72(p) is taken into

account in determining an individual’s

excess distributions, as provided in

§ 54.4981A–1T, Q&A a–8.

Q–12: Is a deemed distribution under

section 72(p) treated as an actual

distribution for purposes of the

qualification requirements of section

401, the distribution provisions of

section 402, or the distribution

restrictions of section 401(k)(2)(B) or

403(b)(11)?

A–12: No. Thus, for example, if a

participant in a money purchase plan

who is an active employee has a deemed

distribution under section 72(p), the

plan will not be considered to have

made an in-service distribution to the

participant in violation of the

qualification requirements applicable to

money purchase plans. Similarly, the

deemed distribution is not eligible to be

rolled over to an eligible retirement plan

and the participant is not eligible to

elect income averaging with respect to

the deemed distribution. See also

§§ 1.402(c)–2, Q&A–4(d) and § 1.401(k)–

1(d)(6)(ii).

Q–13: How does a reduction (offset) of

an account balance in order to repay a

plan loan differ from a deemed

distribution?

A–13: (a) Difference between deemed

distribution and plan loan offset

amount. (1) Loans to a participant from

a qualified employer plan can give rise

to two types of taxable distributions—

(i) A deemed distribution pursuant to

section 72(p); and

(ii) A distribution of an offset amount.

(2) As described in Q&A–4 of this

section, a deemed distribution occurs

when the requirements of Q&A–3 of this

section are not satisfied, either when the

loan is made or at a later time. A

deemed distribution is treated as a

distribution to the participant or

beneficiary only for certain tax purposes

and is not a distribution of the accrued

benefit. A distribution of a plan loan

offset amount (as defined in § 1.402(c)–

2, Q&A–9(b)) occurs when, under the

terms governing a plan loan, the accrued

benefit of the participant or beneficiary

is reduced (offset) in order to repay the

loan (including the enforcement of the

plan’s security interest in the accrued

benefit). A distribution of a plan loan

offset amount could occur in a variety

of circumstances, such as where the

terms governing the plan loan require

that, in the event of the participant’s

request for a distribution, a loan be

repaid immediately or treated as in

default.

(b) Plan loan offset. In the event of a

plan loan offset, the amount of the

account balance that is offset against the

loan is an actual distribution for

purposes of the Internal Revenue Code,

not a deemed distribution under section

72(p). Accordingly, a plan may be

prohibited from making such an offset

under the provisions of section 401(a),

401(k)(2)(B) or 403(b)(11) prohibiting or

limiting distributions to an active

employee. See § 1.402(c)–2, Q&A–9(c)

Example 6.

Q–14: How is the amount includible

in income as a result of a deemed

distribution under section 72(p)

required to be reported?

A–14: The amount includible in

income as a result of a deemed

distribution under section 72(p) is

required to be reported on Form 1099–

R (or any other form prescribed by the

Commissioner).

Q–15: What withholding rules apply

to plan loans?

A–15: To the extent that a loan, when

made, is a deemed distribution or an

account balance is reduced (offset) to

repay a loan, the amount includible in

income is subject to withholding. If a

deemed distribution of a loan or a loan

repayment by benefit offset results in

income at a date after the date the loan

is made, withholding is required only if

a transfer of cash or property (excluding

employer securities) is made to the

participant or beneficiary from the plan

at the same time. See §§ 35.3405–1(f)(4)

and 31.3405(c)–1, Q&A–9 and Q&A–11

of this chapter for further guidance on

withholding rules.

Q–16: If a loan fails to satisfy the

requirements of Q&A–3 of this section

and is a prohibited transaction under

section 4975, is the deemed distribution

of the loan under section 72(p) a

correction of the prohibited transaction?

A–16: A deemed distribution is not a

correction of a prohibited transaction

under section 4975. See §§ 141.4975–13

and 53.4941(e)–1(c)(1) of this chapter

for guidance concerning correction of a

prohibited transaction.

Q–17: What are the income tax

consequences if an amount is

transferred from a qualified employer

plan to a participant or beneficiary as a

loan, but there is an express or tacit

understanding that the loan will not be

repaid?

A–17: If there is an express or tacit

understanding that the loan will not be

repaid, or, for any reason, the

transaction does not create a debtorcreditor relationship, then the amount

transferred is treated as an actual

distribution from the plan for purposes

of the Internal Revenue Code, and is not

treated as a loan or as a deemed

distribution under section 72(p).

Q–18: If a qualified employer plan

maintains a program to invest in

residential mortgages, are loans made

pursuant to the investment program

subject to section 72(p)?

A–18: Residential mortgage loans

made by a plan in the ordinary course

of an investment program are not

subject to section 72(p) if the property

acquired with the loans is the primary

security for such loans and the amount

loaned does not exceed the fair market

value of the property. An investment

program exists only if the plan has

established, in advance of a specific

investment under the program, that a

certain percentage or amount of plan

assets will be invested in residential

mortgages available to persons

purchasing the property who satisfy

commercially customary financial

criteria. Loans will not be considered as

made under an investment program if

the loans are only made available to, or

any loan is earmarked for, any person or

persons who are participants or

beneficiaries in the plan, or if such

loans mature upon a participant’s

termination from employment. In

addition, no loan that benefits an

officer, director, or owner of the

employer maintaining the plan, or his or

her beneficiaries, will be treated as

made under an investment program. No

inference should be drawn that a

transaction under such an investment

program is not a prohibited transaction

under section 503 or 4975 or is not a

violation of the applicable fiduciary

standards for an employee benefit plan,

so that such a loan could be a prohibited

transaction if it does not satisfy the

requirements of 29 CFR 2550.408b–1.

Q–19: When is the effective date of

these regulations?

A–19: This section applies to

assignments, pledges, and loans made

on or after the date that is three months

after the date of publication of the final

regulations in the Federal Register.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95–30874 Filed 12–20–95; 8:45 am]

BILLING CODE 4830–01–U
66238 Federal Register / Vol. 60, No. 245 / Thursday, December 21, 1995 / Proposed Rules

26 CFR Part 1

[PS–7–89]

RIN 1545–AM98

Treatment of Gain From the

Disposition of Interest in Certain

Natural Resource Recapture Property

by S Corporations and Their

Shareholders

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains

proposed regulations under section

1254 of the Internal Revenue Code

relating to the tax treatment by S

corporations and their shareholders of

gain from the disposition by an S

corporation (and a former S corporation)

of certain natural resource recapture

property (section 1254 property after

enactment of the Tax Reform Act of

1986 and oil, gas, or geothermal

property before enactment of the Tax

Reform Act of 1986), and also rules

relating to the disposition of stock in an

S corporation that holds certain natural

resource recapture property. Changes to

the applicable tax law were made by the

Tax Reform Act of 1986, and the

Subchapter S Revision Act of 1982. The

regulations provide the public with

guidance in complying with the

changed tax laws.

DATES: Written comments and requests

for a public hearing must be received by

February 20, 1996.

ADDRESSES: Send comments and

requests for a public hearing to:

CC:DOM:CORP:R (PS–7–89), room 5228,

Internal Revenue Service, P.O. Box

7604, Ben Franklin Station, Washington,

DC 20044. In the alternative,

submissions may be hand-delivered to

CC:DOM:CORP:R (PS–7–89), Room

5228, Internal Revenue Service

Building, 1111 Constitution Avenue,

NW., Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT:

James A. Quinn, 202–622–3060 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information

contained in this notice of proposed

rulemaking has been submitted to the

Office of Management and Budget

(OMB) for review in accordance with

the Paperwork Reduction Act of 1995

(44 U.S.C. 3507).

Comments on the collection of

information should be sent to the Office

of Management and Budget, Attn: Desk

Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503, with copies to the Internal

Revenue Service, Attn: IRS Reports

Clearance Officer PC:FP, Washington,

DC 20224. Comments on the collection

of information should be received by

January 22, 1996.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The collection of information is

contained in § 1.1254–4(c) of the

proposed regulations. This information

is required by the Internal Revenue

Service to verify that taxpayers have

reported the appropriate amount of gain

as ordinary income under section 1254

when a shareholder sells stock in an S

corporation that holds natural resource

recapture property. The likely

respondents are individuals and

businesses and other for-profit

institutions.

Books or records relating to a

collection of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Estimated total annual reporting

burden: 1,000 hours. The estimated

annual burden per respondent varies

from .5 hours to 1.5 hours, depending

on individual circumstances, with an

estimated average of 1 hour.

Estimated number of respondents:

1,000.

Estimated annual frequency of

responses: On occasion.

Background

On June 11, 1980, proposed

amendments to the Income Tax

Regulations, 26 CFR part 1, under

sections 170, 301, 312, 341, 453, 751,

1254, and 1502 of the Internal Revenue

Code of 1954 (Code) were published in

the Federal Register (45 FR 39512).

These amendments were proposed to

conform the regulations to section

205(a), (b), (c)(1) and (2) of the Tax

Reform Act of 1976, Public Law 94–455,

90 Stat. 1533, and section 402(c) of the

Energy Tax Act of 1978, Public Law 95–

618, 92 Stat. 3202, and to make certain

other technical amendments to the

regulations to conform them to section

1(c) of the Act of September 12, 1966,

Public Law 89–570, 80 Stat. 762, section

211(b)(6) of the Tax Reform Act of 1969,

Public Law 91–172, 83 Stat. 570, and

sections 1042(c)(2), 1101(d)(2),

1901(a)(93), and 2110(a) of the Tax

Reform Act of 1976, 90 Stat. 1637, 1658,

1780, 1905. Section 1.1254–3 of the

proposed regulations provided rules

relating to the sale or exchange of stock

in an electing small business

corporation (hereinafter referred to as an

S corporation). Because of the

substantial changes in the tax treatment

of S corporations since the proposed

regulations were issued, the proposed

regulations contained in § 1.1254–3

needed to be completely revised.

This document revises and reproposes

§ 1.1254–3 of the above- referenced

notice of proposed rulemaking as

amendments to the Income Tax

Regulations, 26 CFR part 1, under

section 1254 of the Code, relating to S

corporations (redesignated as § 1.1254–

4). These amendments are proposed to

conform the regulations to section

5(a)(37) of the Subchapter S Revision

Act of 1982, Public Law 97–354, 96 Stat.

1669, and sections 411 and 413 of the

Tax Reform Act of 1986, Public Law 99–

514, 100 Stat. 2225, 2227. The

amendments are to be issued under the

authority contained in sections 1254(b)

and 7805 of the Code.

Explanation of Provisions

These proposed regulations contain

rules for applying the provisions of

section 1254 to the disposition of

natural resource recapture property by

an S corporation (and a former S

corporation) and the disposition of S

corporation stock.

The proposed regulations provide that

the recognition of ordinary income

under section 1254 upon the disposition

of natural resource recapture property

by an S corporation is generally

computed at the shareholder level.

Determining the amount of ordinary

income to be recognized under section

1254 at the shareholder level is

appropriate because the determination

of section 1254 costs can be affected by

shareholder elections and

characteristics. See, for example,

sections 59(e) and 1363(c)(2)(A).

Similarly, in the case of oil and gas

properties, gain on the disposition of the

property and depletion with respect to

the property are computed at the

shareholder level. See section

613A(c)(11).

The proposed regulations also contain

rules relating to the recognition of

ordinary income under section 1254

upon a sale or exchange of S corporation

stock. Under section 1254(b)(2), rules

similar to the rules of section 751 are to

be applied to that portion of the excess

of the amount realized over the adjusted

basis of the stock that is attributable to

section 1254 costs. Pursuant to section

1254(b)(2), the proposed regulations

provide that, as a general rule, a
Federal Register / Vol. 60, No. 245 / Thursday, December 21, 1995 / Proposed Rules 66239

shareholder must treat any gain

recognized on a sale or exchange of S

corporation stock as ordinary income to

the extent of the shareholder’s section

1254 costs with respect to the shares

sold or exchanged.

The proposed regulations provide two

exceptions to the general rule for

determining the amount treated as

ordinary income under section 1254

upon a sale or exchange of stock. The

first exception is that the general rule

does not apply to the extent that the

shareholder establishes that the gain is

not attributable to the section 1254

costs. The portion of the gain recognized

that is not attributable to section 1254

costs is that portion of the gain

recognized that exceeds the amount of

ordinary income that the shareholder

would have recognized under section

1254 (with respect to the shares sold or

exchanged) if, immediately prior to the

sale or exchange of the stock, the

corporation had sold at fair market

value all of the corporation’s property

the disposition of which would result in

the recognition by the shareholder of

ordinary income under section 1254. To

establish that a portion of the gain

recognized is not attributable to a

shareholder’s section 1254 costs, the

shareholder must attach to the

shareholder’s tax return a statement

detailing the shareholder’s share of the

fair market value and basis, and the

shareholder’s section 1254 costs, for

each of the S corporation’s natural

resource recapture properties held

immediately before the sale or exchange

of stock.

The second exception to the general

rule for sales or exchanges of stock is

that, in the case of a contribution of

property to the S corporation prior to a

stock sale or exchange pursuant to a

plan a principal purpose of which is to

avoid the recognition of ordinary

income under section 1254, the selling

or exchanging shareholder must

recognize as ordinary income under

section 1254 the amount of ordinary

income the shareholder would have

recognized under section 1254 (with

respect to the shares sold or exchanged)

had the S corporation sold all of its

natural resource recapture property the

disposition of which would result in

ordinary income under section 1254.

Section 1.1254–4(c)(3) Example 3 of the

proposed regulations illustrates this

exception. The proposed regulations

also provide rules for determining an S

corporation shareholder’s section 1254

costs. Generally, an S corporation

shareholder’s section 1254 costs with

respect to any natural resource

recapture property held by the

corporation include all of the

shareholder’s section 1254 costs with

respect to the property while in the

hands of the S corporation. In the case

of a person (acquiring shareholder) who

acquires stock from another

shareholder, the proposed regulations

provide that the acquiring shareholder’s

section 1254 costs are zero if the

acquiring shareholder’s basis for the

stock transferred is determined by

reference to its cost (within the meaning

of section 1012) or by reference to the

fair market value of the stock on the

date of the decedent’s death or on the

applicable date provided in section

2032 (relating to alternate valuation

date). However, an acquiring

shareholder’s section 1254 costs include

any section 1254 costs paid or incurred

before the decedent’s death, to the

extent that the basis of the stock is

reduced under section 1014(b)(9)

(relating to adjustments to basis if the

property is acquired from a decedent

prior to death). For stock that is

acquired in a transfer that is a gift, in a

transfer that is part sale or exchange and

part gift, or a transfer described in

section 1041, the acquiring shareholder

generally acquires the section 1254 costs

of the transferor but reduces the section

1254 costs by the amount of any gain

treated as ordinary income under

section 1254 by the transferor on the

transfer.

The proposed regulations provide

rules for applying section 1254 to the

shareholders of an S corporation that

incurred section 1254 costs while it was

a C corporation (former C corporation).

In the case of a C corporation that holds

natural resource recapture property and

that elects to be an S corporation, each

shareholder’s section 1254 costs as of

the beginning of the corporation’s first

taxable year as an S corporation include

a pro rata share of the section 1254 costs

of the corporation as of the close of the

last taxable year that the corporation

was a C corporation.

The proposed regulations also provide

rules for applying section 1254 to a

corporation that holds natural resource

recapture property after the termination

of its S corporation election (former S

corporation). In the case of an S

corporation that becomes a C

corporation, the C corporation’s section

1254 costs with respect to any natural

resource recapture property held by the

corporation as of the beginning of the

corporation’s first taxable year as a C

corporation include the sum of its

shareholders’ section 1254 costs with

respect to the property as of the close of

the last taxable year for which the

corporation was an S corporation. In the

case of an S termination year as defined

in section 1362(e)(4), the shareholders’

section 1254 costs are determined as of

the close of the S short year as defined

in section 1362(e)(1)(A).

Because certain transactions will

change the allocation to the

shareholders of gain or amount realized

from the natural resource recapture

property if the S corporation disposes of

it subsequent to these transactions, the

proposed regulations require that

section 1254 costs be reallocated to

reflect the effects of these transactions.

Transactions requiring reallocation of

the section 1254 costs are transactions

involving the issuance of stock by an S

corporation in a reorganization or

otherwise, and transfers of natural

resource recapture property to the S

corporation in exchange for stock of the

S corporation (for example, in a section

351 transaction or in a reorganization).

The rules for former S corporations

and the rules for allocating section 1254

costs upon certain transfers require the

S corporation to determine the aggregate

of its shareholders’ section 1254 costs.

The proposed regulations provide rules

for the S corporation to apply in

determining a shareholder’s section

1254 costs with respect to natural

resource recapture property held by the

S corporation. In general, the S

corporation may determine a

shareholder’s section 1254 costs by

using written data provided by the

shareholder or by applying certain

assumptions.

These regulations are proposed to

apply to dispositions of natural resource

recapture property by an S corporation

(and a former S corporation) and

dispositions of S corporation stock

occurring after publication of these

regulations as final regulations in the

Federal Register.

Comments and Requests for a Public

Hearing

Before the adoption of these proposed

regulations, consideration will be given

to any written comments that are timely

submitted (preferably an original and

eight copies) to the IRS. All comments

will be available for public inspection

and copying. A public hearing will be

held upon written request to the

Internal Revenue Service by any person

who also submits written comments. If

a public hearing is held, notice of the

time and place will be published in the

Federal Register.

Special Analyses

It has been determined that this

proposed regulation is not a significant

regulatory action as defined in

Executive Order 12866. Therefore, a

regulatory assessment is not required. It

also has been determined that section
66240 Federal Register / Vol. 60, No. 245 / Thursday, December 21, 1995 / Proposed Rules

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, and, therefore, a Regulatory

Flexibility Analysis is not required.

Pursuant to section 7805(f) of the

Internal Revenue Code, this notice of

proposed rulemaking will be submitted

to the Chief Counsel for Advocacy of the

Small Business Administration for

comment on its impact on small

business.

Drafting Information

The principal author of these

regulations is James A. Quinn of the

Office of Assistant Chief Counsel

(Passthroughs and Special Industries),

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.

Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 continues to read in part as

follows:

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

Section 1.1254–4 also issued under 26

U.S.C. 1254(b). * * *

Par. 2. Section 1.1254–0 is amended

by revising the entry for § 1.1254–4 to

read as follows:

§ 1.1254–0 Table of contents for section

1254 recapture rules.

* * * * *

§ 1.1254–4 Special rules for S corporations

and their shareholders.

(a) In general.

(b) Determination of gain treated as

ordinary income under section 1254

upon a disposition of natural resource

recapture property by an S corporation.

(1) General rule.

(2) Examples.

(c) Character of gain recognized by a

shareholder upon a sale or exchange of

S corporation stock.

(1) General rule.

(2) Exceptions.

(3) Examples.

(d) Section 1254 costs of a

shareholder.

(e) Section 1254 costs of an acquiring

shareholder after certain acquisitions.

(1) Basis determined under section

1012.

(2) Basis determined by reason of the

application of section 1014(a).

(3) Basis determined by reason of the

application of section 1014(b)(9).

(4) Gifts and section 1041 transfers.

(f) Special rules for former S

corporations and former C corporations.

(1) Section 1254 costs of an S

corporation that was formerly a C

corporation.

(2) Examples.

(3) Section 1254 costs of a C

corporation that was formerly an S

corporation.

(g) Determination of a shareholder’s

section 1254 costs upon certain stock

transactions.

(1) Issuance of stock.

(2) Natural resource recapture

property acquired in exchange for stock.

(3) Treatment of nonvested stock.

(4) Exception.

(5) Aggregate of S corporation

shareholders’ section 1254 costs with

respect to natural resource recapture

property held by the S corporation

(6) Examples.

(h) Effective date.

* * * * *

Par. 3. Section 1.1254–4 is amended

by adding text to read as follows:

§ 1.1254–4 Special rules for S corporations

and their shareholders.

(a) In general. This section provides

rules for applying the provisions of

section 1254 to S corporations and their

shareholders upon the disposition by an

S corporation (or a former S

corporation) of natural resource

recapture property and upon the

disposition by a shareholder of stock of

an S corporation that holds natural

resource recapture property.

(b) Determination of gain treated as

ordinary income under section 1254

upon a disposition of natural resource

recapture property by an S

corporation—(1) General rule. Upon a

disposition of natural resource recapture

property by an S corporation, the

amount of gain treated as ordinary

income under section 1254 is

determined at the shareholder level.

Each shareholder must recognize as

ordinary income under section 1254 the

lesser of—

(i) The shareholder’s section 1254

costs with respect to the property

disposed of; or

(ii) The shareholder’s share of the

amount, if any, by which the amount

realized on the sale, exchange, or

involuntary conversion, or the fair

market value of the property upon any

other disposition (including a

distribution), exceeds the adjusted basis

of the property.

(2) Examples. The following examples

illustrate the provisions of paragraph

(b)(1) of this section:

Example 1. Disposition of natural resource

recapture property other than oil and gas

property. A and B are equal shareholders in

X, an S corporation. On January 1, 1995, X

acquires for $90,000 an undeveloped mineral

property, its sole property. During 1995, X

expends and deducts $100,000 in developing

the property. On January 15, 1996, X sells the

property for $250,000 when X’s basis in the

property is $90,000. Thus, X recognizes gain

of $160,000 on the sale. A and B’s share of

the $160,000 gain recognized is $80,000 each.

Each shareholder has $50,000 of section 1254

costs with respect to the property. Under

these circumstances, A and B each are

required to recognize $50,000 of the $80,000

of gain on the sale of the property as ordinary

income under section 1254.

Example 2. Disposition of oil and gas

property the adjusted basis of which is

allocated to the shareholders under section

613A(c)(11). C and D are equal shareholders

in Y, an S corporation. On January 1, 1995,

Y acquires for $150,000 an undeveloped oil

and gas property, its sole property. During

1995, Y expends in developing the property

$40,000 in intangible drilling costs which it

elects to expense under section 263(c). On

January 15, 1996, Y sells the property for

$200,000. C and D’s share of the $200,000

amount realized on the sale is $100,000 each.

C and D each have a basis of $75,000 in the

property and $20,000 of section 1254 costs

with respect to the property. Under these

circumstances, C and D each are required to

recognize $20,000 of the $25,000 gain on the

sale of the property as ordinary income under

section 1254.

(c) Character of gain recognized by a

shareholder upon a sale or exchange of

S corporation stock—(1) General rule.

Except as provided in paragraph (c)(2)

of this section, if an S corporation

shareholder recognizes gain upon a sale

or exchange of stock in the S

corporation (determined without regard

to section 1254), the gain is treated as

ordinary income under section 1254 to

the extent of the shareholder’s section

1254 costs (with respect to the shares

sold or exchanged).

(2) Exceptions—(i) Gain not

attributable to section 1254 costs—(A)

General rule. Paragraph (c)(1) of this

section does not apply to any portion of

the gain recognized on the sale or

exchange of the stock that the taxpayer

establishes is not attributable to section

1254 costs. The portion of the gain

recognized that is not attributable to

section 1254 costs is that portion of the

gain recognized that exceeds the amount

of ordinary income that the shareholder

would have recognized under section

1254 (with respect to the shares sold or

exchanged) if, immediately prior to the

sale or exchange of the stock, the

corporation had sold at fair market

value all of the corporation’s property

the disposition of which would result in

the recognition by the shareholder of

ordinary income under section 1254.
Federal Register / Vol. 60, No. 245 / Thursday, December 21, 1995 / Proposed Rules 66241

(B) Substantiation. To establish that a

portion of the gain recognized is not

attributable to a shareholder’s section

1254 costs so as to qualify for the

exception contained in paragraph

(c)(2)(i)(A) of this section, the

shareholder must attach to the

shareholder’s tax return a statement

detailing the shareholder’s share of the

fair market value and basis, and the

shareholder’s section 1254 costs, for

each of the S corporation’s natural

resource recapture properties held

immediately before the sale or exchange

of stock.

(ii) Transactions entered into as part

of a plan to avoid recognition of

ordinary income under section 1254. In

the case of a contribution of property

prior to a sale or exchange of stock

pursuant to a plan a principal purpose

of which is to avoid recognition of

ordinary income under section 1254,

paragraph (c)(1) of this section does not

apply. Instead, the amount recognized

as ordinary income under section 1254

is the amount of ordinary income the

selling or exchanging shareholder

would have recognized under section

1254 (with respect to the shares sold or

exchanged) had the S corporation sold

its natural resource recapture property

the disposition of which would have

resulted in the recognition of ordinary

income under section 1254. The amount

recognized as ordinary income under

the preceding sentence reduces the

amount realized on the sale or exchange

of the stock. This reduced amount

realized is used in determining any gain

or loss on the sale or exchange.

(3) Examples. The following examples

illustrate the provisions of this

paragraph (c):

Example 1. Application of general rule

upon a sale of S corporation stock. C and D

are equal shareholders in Y, an S corporation.

As of January 1, 1995, Y holds two mining

properties: Blackacre, with an adjusted basis

of $5,000 and a fair market value of $35,000,

and Whiteacre, with an adjusted basis of

$20,000 and a fair market value of $15,000.

Y also holds securities with a basis of $5,000

and a fair market value of $10,000. On

January 1, 1995, D sells 50 percent of D’s Y

stock to E for $15,000. As of the date of the

sale, D’s adjusted basis in the Y stock sold

is $7,500, and D has $18,000 of section 1254

costs with respect to Blackacre and $12,000

of section 1254 costs with respect to

Whiteacre. Under this paragraph (c), the gain

recognized by D upon the sale of Y stock is

treated as ordinary income to the extent of

D’s section 1254 costs with respect to the

stock sold, unless D establishes that a portion

of such excess is not attributable to D’s

section 1254 costs. However, because D

would recognize $7,500 in ordinary income

under section 1254 with respect to the stock

sold if Y sold Blackacre (the only asset the

disposition of which would result in

ordinary income to D under section 1254),

the $7,500 of gain recognized by D upon the

sale of D’s Y stock is attributable to D’s

section 1254 costs. Therefore, upon the sale

of stock to E, D recognizes $7,500 of ordinary

income under this paragraph (c).

Example 2. Sale of S corporation stock

where gain is not entirely attributable to

section 1254 costs. Assume the same facts as

in Example 1, except that Blackacre has a fair

market value of $25,000, and the securities

have a fair market value of $20,000.

Immediately prior to the sale of stock to E,

if Y had sold Blackacre (its only asset the

disposition of which would result in the

recognition of ordinary income to D under

section 1254), D would recognize $5,000 in

ordinary income with respect to the stock

sold under section 1254. D attaches a

statement to D’s tax return for 1995 detailing

D’s share of the fair market values and bases,

and D’s section 1254 costs with respect to

Blackacre and Whiteacre. Therefore, upon

the sale of stock to E, of the $7,500 gain

recognized by D, $5,000 is ordinary income

under this paragraph (c).

Example 3. Contribution of property prior

to sale of S corporation stock as part of a

plan to avoid recognition of ordinary income

under section 1254. H owns all of the stock

of Z, an S corporation. As of January 1, 1995,

H has $3,000 of section 1254 costs with

respect to property P, which is natural

resource recapture property and Z’s only

asset. Property P has an adjusted basis of

$5,000 and a fair market value of $8,000. H

has a basis of $5,000 in Z stock, which has

a fair market value of $8,000. On January 1,

1995, H contributes securities to Z which

have a basis of $7,000 and a fair market value

of $4,000. On April 15, 1995, H sells all of

the Z stock to J for $12,000. On that date, H’s

adjusted basis in the Z stock is also $12,000.

Based on all the facts and circumstances, the

sale of stock is part of a plan (along with the

contribution by H of the securities to Z) that

has a principal purpose to avoid recognition

of ordinary income under section 1254.

Consequently, under paragraph (c)(2)(ii) of

this section, H must recognize $3,000 as

ordinary income under section 1254, the

amount of ordinary income that H would

recognize as ordinary income under section

1254 if property P were sold at fair market

value. In addition, H reduces the amount

realized on the sale of the stock ($12,000) by

$3,000. As a result, H also recognizes a

$3,000 capital loss on the sale of the stock

($9,000 amount realized less $12,000

adjusted basis).

(d) Section 1254 costs of a

shareholder. An S corporation

shareholder’s section 1254 costs with

respect to any natural resource

recapture property held by the

corporation include all of the

shareholder’s section 1254 costs with

respect to the property in the hands of

the S corporation. See § 1.1254–1(b)(1)

for the definition of section 1254 costs.

(e) Section 1254 costs of an acquiring

shareholder after certain acquisitions—

(1) Basis determined under section

1012. If stock in an S corporation that

holds natural resource recapture

property is acquired and the acquiring

shareholder’s basis for the stock is

determined solely by reference to its

cost (within the meaning of section

1012), the amount of section 1254 costs

with respect to the property held by the

corporation in the acquiring

shareholder’s hands is zero on the

acquisition date.

(2) Basis determined by reason of the

application of section 1014(a). If stock

in an S corporation that holds natural

resource recapture property is acquired

from a decedent and the acquiring

shareholder’s basis is determined, by

reason of the application of section

1014(a), solely by reference to the fair

market value of the stock on the date of

the decedent’s death or on the

applicable date provided in section

2032 (relating to alternate valuation

date), the amount of section 1254 costs

with respect to the property held by the

corporation in the acquiring

shareholder’s hands is zero on the

acquisition date.

(3) Basis determined by reason of the

application of section 1014(b)(9). If

stock in an S corporation that holds

natural resource recapture property is

acquired before the death of the

decedent, the amount of section 1254

costs with respect to the property held

by the corporation in the acquiring

shareholder’s hands includes the

amount, if any, of the section 1254 costs

deducted by the acquiring shareholder

before the decedent’s death, to the

extent that the basis of the stock

(determined under section 1014(a)) is

required to be reduced under section

1014(b)(9) (relating to adjustments to

basis when the property is acquired

before the death of the decedent).

(4) Gifts and section 1041 transfers. If

stock is acquired in a transfer that is a

gift, in a transfer that is a part sale or

exchange and part gift, or in a transfer

that is described in section 1041(a), the

amount of section 1254 costs with

respect to the property held by the

corporation in the acquiring

shareholder’s hands immediately after

the transfer is an amount equal to—

(i) The amount of section 1254 costs

with respect to the property held by the

corporation in the hands of the

transferor immediately before the

transfer; minus

(ii) The amount of any gain

recognized as ordinary income under

section 1254 by the transferor upon the

transfer.

(f) Special rules for former S

corporations and former C

corporations—(1) Section 1254 costs of

an S corporation that was formerly a C

corporation. In the case of a C
66242 Federal Register / Vol. 60, No. 245 / Thursday, December 21, 1995 / Proposed Rules

corporation that holds natural resource

recapture property and that elects to be

an S corporation, each shareholder’s

section 1254 costs as of the beginning of

the corporation’s first taxable year as an

S corporation include a pro rata share

of the section 1254 costs of the

corporation as of the close of the last

taxable year that the corporation was a

C corporation.

(2) Examples. The following examples

illustrate the application of the

provisions of paragraph (f)(1) of this

section:

Example 1. Sale of natural resource

recapture property held by an S corporation

that was formerly a C corporation—(i) Y is

a C corporation that elects to be an S

corporation effective January 1, 1996. On that

date, Y owns Oil Well, which is natural

resource recapture property and a capital

asset. Y has section 1254 costs of $20,000 as

of the close of the last taxable year that it was

a C corporation. On January 1, 1996, Oil Well

has a value of $200,000 and a basis of

$100,000. Thus, under section 1374, Y’s net

unrealized built-in gain is $100,000. Also on

that date, Y’s basis in Oil Well is allocated

to A, Y’s sole shareholder, under section

613A(c)(11) and the section 1254 costs are

allocated to A under § 1.1254–4(f)(1). In

addition, A has a basis in A’s Y stock of

$100,000.

(ii) On November 1, 1996, Y sells Oil Well

for $250,000. During 1996, Y has taxable

income greater than $100,000, and no other

transactions or items treated as recognized

built-in gain or loss. Under section 1374, Y

has net recognized built-in gain of $100,000.

Assuming a tax rate of 35 percent on capital

gain, Y has a tax of $35,000 under section

1374. The tax of $35,000 is treated as a

capital loss under section 1366(f)(2). A has a

realized gain on the sale of $150,000

($250,000 minus $100,000) of which $20,000

is recognized as ordinary income under

section 1254, and $130,000 is recognized as

capital gain. Consequently, A recognizes

ordinary income of $20,000 and net capital

gain of $95,000 ($130,000 minus $35,000) on

the sale.

Example 2. Sale of stock followed by sale

of natural resource recapture property held

by an S corporation that was formerly a C

corporation—(i) Assume the same facts as in

Example 1(i). On November 1, 1996, A sells

all of A’s Y stock to P for $250,000. A has

a realized gain on the sale of $150,000

($250,000 minus $100,000) of which $20,000

is recognized as ordinary income under

section 1254, and $130,000 is recognized as

capital gain.

(ii) On November 2, 1996, Y sells Oil Well

for $250,000. During 1996, Y has taxable

income greater than $100,000, and no other

transactions or items treated as recognized

built-in gain or loss. Under section 1374, Y

has net recognized built-in gain of $100,000.

Assuming a tax rate of 35 percent on capital

gain, Y has a tax of $35,000 under section

1374. The tax of $35,000 is treated as a

capital loss under section 1366(f)(2). P has a

realized gain on the sale of $150,000

($250,000 minus $100,000), which is

recognized as capital gain. Consequently, P

recognizes net capital gain of $115,000

($150,000 minus $35,000) on the sale.

(3) Section 1254 costs of a C

corporation that was formerly an S

corporation. In the case of an S

corporation that becomes a C

corporation, the C corporation’s section

1254 costs with respect to any natural

resource recapture property held by the

corporation as of the beginning of the

corporation’s first taxable year as a C

corporation include the sum of its

shareholders’ section 1254 costs with

respect to the property as of the close of

the last taxable year that the corporation

was an S corporation. In the case of an

S termination year as defined in section

1362(e)(4), the shareholders’ section

1254 costs are determined as of the

close of the S short year as defined in

section 1362(e)(1)(A). See paragraph

(g)(5) of this section for rules on

determining the aggregate amount of the

shareholders’ section 1254 costs.

(g) Determination of a shareholder’s

section 1254 costs upon certain stock

transactions—(1) Issuance of stock.

Upon an issuance of stock (whether

such stock is newly-issued or had been

held as treasury stock) by an S

corporation in a reorganization or

otherwise—

(i) Each recipient of shares must be

allocated a pro rata share (determined

solely with respect to the shares issued

in the transaction) of the aggregate of the

S corporation shareholders’ section

1254 costs with respect to natural

resource recapture property held by the

S corporation immediately before the

issuance (as determined pursuant to

paragraph (g)(5) of this section); and

(ii) Each pre-existing shareholder

must reduce his or her section 1254

costs with respect to natural resource

recapture property held by the S

corporation immediately before the

issuance by an amount equal to the preexisting shareholder’s section 1254 costs

immediately before the issuance

multiplied by the percentage of stock of

the corporation issued in the

transaction.

(2) Natural resource recapture

property acquired in exchange for stock.

If natural resource recapture property is

transferred to an S corporation in

exchange for stock of the S corporation

(for example, in a section 351

transaction, or in a reorganization

described in section 368), the S

corporation must allocate to its

shareholders a pro rata share of the S

corporation’s section 1254 costs with

respect to the property immediately

after the transaction (as determined

under § 1.1254–3(b)(1)).

(3) Treatment of nonvested stock.

Stock issued in connection with the

performance of services that is

substantially nonvested (within the

meaning of § 1.83–3(b)) is treated as

issued for purposes of this section at the

first time it is treated as outstanding

stock of the S corporation for purposes

of section 1361.

(4) Exception. Paragraph (g)(1) of this

section does not apply to stock issued

in exchange for stock of the same S

corporation (as for example, in a

recapitalization described in section

368(a)(1)(E)).

(5) Aggregate of S corporation

shareholders’ section 1254 costs with

respect to natural resource recapture

property held by the S corporation—(i)

In general. The aggregate of S

corporation shareholders’ section 1254

costs is equal to the sum of each

shareholder’s section 1254 costs. The S

corporation must determine each

shareholder’s section 1254 costs under

either paragraph (g)(5)(i)(A) (written

data) or paragraph (g)(5)(i)(B)

(assumptions) of this section. The S

corporation may determine the section

1254 costs of some shareholders under

paragraph (g)(5)(i)(A) of this section and

of others under paragraph (g)(5)(i)(B) of

this section.

(A) Written data. An S corporation

may determine a shareholder’s section

1254 costs by using written data

provided by a shareholder showing the

shareholder’s section 1254 costs with

respect to natural resource recapture

property held by the S corporation

unless the S corporation knows or has

reason to know that the written data is

inaccurate. If an S corporation does not

receive written data upon which it may

rely, the S corporation must use the

assumptions provided in paragraph

(g)(5)(i)(B) of this section in determining

a shareholder’s section 1254 costs.

(B) Assumptions. An S corporation

that does not use written data pursuant

to paragraph (g)(5)(i)(A) of this section

to determine a shareholder’s section

1254 costs must use the following

assumptions to determine the

shareholder’s section 1254 costs.

(1) The shareholder deducted his or

her share of the amount of deductions

under sections 263(c), 616, and 617 in

the first year in which the shareholder

could claim a deduction for such

amounts, unless in the case of

expenditures under sections 263(c) or

616 the S corporation elected to

capitalize such amounts;

(2) The shareholder was not subject to

the following limitations with respect to

the shareholder’s depletion allowance

under section 611, except to the extent

a limitation applied at the corporate
Federal Register / Vol. 60, No. 245 / Thursday, December 21, 1995 / Proposed Rules 66243

level: the taxable income limitation of

section 613(a); the depletable quantity

limitations of section 613A(c); or the

limitations of sections 613A(d)(2), (3),

and (4) (exclusion of retailers and

refiners).

(6) Examples. The following examples

illustrate the provisions of this

paragraph (g):

Example 1. Transfer of natural resource

recapture property to an S corporation in a

section 351 transaction. As of January 1,

1996, A owns all the stock (20 shares) in X,

an S corporation. X holds property that is not

natural resource recapture property that has

a fair market value of $2,000 and an adjusted

basis of $2,000. On January 1, 1996, B

transfers natural resource recapture property,

Property P, to X in exchange for 80 shares of

X stock in a transaction that qualifies under

section 351. Property P has a fair market

value of $8,000 and an adjusted basis of

$5,000. Pursuant to section 351, B does not

recognize gain on the transaction.

Immediately prior to the transaction, B’s

section 1254 costs with respect to Property P

equaled $6,000. Under § 1.1254–2(c)(1), B

does not recognize any gain under section

1254 on the section 351 transaction and,

under § 1.1254–3(b)(1), X’s section 1254 costs

with respect to Property P immediately after

the contribution equal $6,000. Under

paragraph (g)(2) of this section, each

shareholder is allocated a pro rata share of

X’s section 1254 costs. The pro rata share of

X’s section 1254 costs that is allocated to A

equals $1,200 (20 percent interest in X

multiplied by X’s $6,000 of section 1254

costs). The pro rata share of X’s section 1254

costs that is allocated to B equals $4,800 (80

percent interest in X multiplied by X’s $6,000

of section 1254 costs).

Example 2. Contribution of money in

exchange for stock of an S corporation

holding natural resource recapture property.

As of January 1, 1996, A and B each own 50

percent of the stock (50 shares each) in X, an

S corporation. X holds natural resource

recapture property, Property P, which has a

fair market value of $20,000 and an adjusted

basis of $14,000. A’s and B’s section 1254

costs with respect to Property P are $4,000

and $1,500, respectively. On January 1, 1996,

C contributes $20,000 to X in exchange for

100 shares of X’s stock. Under paragraph

(g)(1)(i) of this section, X must allocate to C

a pro rata share of its shareholders’ section

1254 costs. Using the assumptions set forth

in paragraph (g)(5)(i)(B) of this section, X

determines that A’s section 1254 costs with

respect to natural resource recapture property

held by X equal $4,500. Using written data

provided by B, X determines that B’s section

1254 costs with respect to Property P equal

$1,500. Thus, the aggregate of X’s

shareholders’ section 1254 costs equals

$6,000. C’s pro rata share of the $6,000 of

section 1254 costs equals $3,000 (C’s 50

percent interest in X multiplied by $6,000).

Under paragraph (g)(1)(ii) of this section, A’s

section 1254 costs are reduced by $2,000 (A’s

actual section 1254 costs ($4,000) multiplied

by 50 percent). B’s section 1254 costs are

reduced by $750 (B’s actual section 1254

costs ($1,500) multiplied by 50 percent).

Example 3. Merger involving an S

corporation that holds natural resource

recapture property. X, an S corporation with

one shareholder, A, holds as its sole asset

natural resource recapture property that has

a fair market value of $120,000 and an

adjusted basis of $40,000. A has section 1254

costs with respect to the property of $60,000.

For valid business reasons, X merges into Y,

an S corporation with one shareholder, B, in

a reorganization described in section

368(a)(1)(A). Y holds property that is not

natural resource recapture property that has

a fair market value of $120,000 and basis of

$120,000. Under paragraph (c) of this section,

A does not recognize ordinary income under

section 1254 upon the exchange of stock in

the merger because A did not otherwise

recognize gain on the merger. Under

paragraph (g)(2) of this section, Y must

allocate to A and B a pro rata share of its

$60,000 of section 1254 costs. Thus, A and

B are each allocated $30,000 of section 1254

costs (50 percent interest in X, each,

multiplied by $60,000).

(h) Effective date. This section applies

to dispositions of natural resource

recapture property by an S corporation

(and a former S corporation) and

dispositions of S corporation stock

occurring after publication of these

regulations as final regulations in the

Federal Register.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95–30832 Filed 12–20–95; 8:45 am]

BILLING CODE 4830–01–U

26 CFR Part 31

[IA–33–95]

RIN 1545–AT77

Effective Date of Temporary Backup

Withholding Regulations

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

by cross-reference to temporary

regulations.

SUMMARY: In the Rules and Regulations

section of this issue of the Federal

Register, the IRS is issuing temporary

regulations relating to the effective date

of the Temporary Employment Tax

Regulations under the Interest and

Dividend Tax Compliance Act of 1983,

relating to backup withholding,

statement mailing requirements, and

due diligence. The text of those

temporary regulations also serves as the

text of these proposed regulations.

DATES: Written comments and requests

for a public hearing must be received by

March 20, 1996.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (IA–33–95), room

5228, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044. In the alternative,

submissions may be hand delivered

between the hours of 8 a.m. and 5 p.m.

to: CC:DOM:CORP:R (IA–33–95),

Courier’s Desk, Internal Revenue

Service, 1111 Constitution Avenue, NW,

Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the regulations, Renay

France, (202) 622–4910; concerning

submissions, Michael Slaughter, (202)

622–7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Temporary regulations in the Rules

and Regulations section of this issue of

the Federal Register amend the

Temporary Employment Tax

Regulations under the Interest and

Dividend Tax Compliance Act of 1983

(26 CFR part 35a). The temporary

regulations contain rules relating to the

effective date of §§ 35a.9999–1,

35a.9999–2, 35a.9999–3, 35a.9999–3A,

35a.9999–4T, and 35a.9999–5.

The text of those temporary

regulations also serves as the text of

these proposed regulations. The

preamble to the temporary regulations

explains the temporary regulations.

Special Analyses

It has been determined that this notice

of proposed rulemaking is not a

significant regulatory action as defined

in EO 12866. Therefore, a regulatory

assessment is not required. 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, and

therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to

section 7805(f) of the Internal Revenue

Code, this notice of proposed

rulemaking will be submitted to the

Chief Counsel for Advocacy of the Small

Business Administration for comment

on its impact on small business.

Comments and Requests for a Public

Hearing

Before these proposed regulations are

adopted as final regulations,

consideration will be given to any

written comments (a signed original and

eight (8) copies) that are submitted

timely to the IRS. All comments will be

available for public inspection and

copying. A public hearing may be

scheduled if requested in writing by any

person that timely submits written

comments. If a public hearing is

scheduled, notice of the date, time, and