Final Regulations Issued on S Corporation COD Income Exclusion and Tax Attributes

The IRS and Treasury Department issued final regulations (TD 9469) this week governing how an S corporation reduces its tax attributes under IRC § 108(b) when the S corporation has discharge of indebtedness (COD) income that is excluded from gross income under section 108(a).

The regulations address situations in which the aggregate amount of the shareholders’ disallowed section 1366(d) losses and deductions that are treated as a net operating loss (NOL) tax attribute of the S corporation exceeds the amount of the S corporation’s excluded COD income. The final regulations generally adopt the provisions of proposed regulations that were issued in August 2008 (REG-102822-08).

Background

Section 108(a) excludes COD income from gross income if the discharge occurs while the taxpayer is bankrupt or insolvent, in which case the exclusion from income is limited to the amount by which the taxpayer is insolvent. Under section 108(b), the taxpayer must reduce certain specified tax attributes—in a specified order—to the extent COD income is excluded from gross income. The first tax attribute reduced is any NOL and any NOL carryover for the tax year of the discharge.

Under the rules of section 1366(a), if an S corporation excludes COD income from its gross income under section 108(a), the amount excluded reduces the S corporation’s tax attributes under section 108(b). The reduction of tax attributes occurs after the S corporation’s items of income, loss, deduction and credit for the tax year of the discharge pass through to its shareholders under section 1366(a).

Final Regulations

The final regulations provide an ordering approach for determining the character of the amount of the S corporation’s excess deemed NOL that is allocated to a shareholder. The approach is based on one commentator’s recommendation that the final regulations’ approach be consistent with the method for determining the character of a shareholder’s losses and deductions under section 1366(d). Under this approach, an S corporation’s excess deemed NOL that is allocated to a shareholder consists of a proportionate amount of each item of the shareholder’s loss or deduction that is disallowed for the tax year of the discharge under section 1366(d)(1).

The final regulations also modify the shareholder-information reporting requirement so the S corporation does not have to depend on shareholders who fail to furnish information or who provide incorrect information. In certain situations, it may rely on its own books and records as well as other information available to the S corporation to determine a shareholder’s disallowed losses or deductions under section 1366(d)(1), provided the S corporation knows that the amount reported by the shareholder is inaccurate or the information, as provided, appears to be incomplete or incorrect.

There are no special rules to provide for consequences to shareholders who either fail to report this information or report incorrect information to the S corporation. However, the IRS and the Treasury Department note in the regulations’ preamble that section 6037(c) requires that a shareholder of an S corporation must treat a “subchapter S item” on his or her return in a manner consistent with its treatment on the S corporation’s return. The preamble states that an S corporation’s excess deemed NOL that is allocated to a shareholder is a “subchapter S item” for purposes of section 6037(c) and that the consequences of failure to comply with section 6037(c) are sufficient to encourage shareholders to cooperate with the S corporation to avoid inconsistencies between the S corporation’s return and the shareholder’s return.

Several people who commented on the proposed regulations recommended that S corporation NOLs carried forward from one or more C corporation tax years should be considered S corporation tax attributes for purposes of section 108(b)(2). The final regulations did not adopt this suggestion.

One commentator suggested that the final regulations should clarify how the allocation rules in Prop. Treas. Reg. § 1.108-7(d)(2) apply when an S corporation, with the consent of all affected shareholders, makes a terminating election. According to the IRS, regardless of whether a terminating election is made, all disallowed losses and deductions of a shareholder under section 1366(d)(1), including disallowed losses and deductions of a terminating shareholder, are treated as an S corporation’s deemed NOL. The impact of a terminating election on the allocation of the COD income, however, may result in a different allocation of the S corporation’s excess deemed NOL among the shareholders. Therefore, the final regulations add an example to clarify how the allocation rules apply when a terminating election is made.

The regulations were effective on Oct. 30, the date of their publication in the Federal Register.