For Tax Professionals  
REG-106219-98 December 16, 1998

Acquisition of an S Corporation by a
Member of a Consolidated Group

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-106219-98] RIN 1545-AW32

TITLE: Acquisition of an S Corporation by a Member of a Consolidated
Group

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations under section
1502. The proposed regulations provide specific rules that apply to
the acquisition of the stock of an S corporation by an affiliated
group of corporations that joins in the filing of a consolidated
return. These rules eliminate the compliance burdens associated with
filing a separate return for the day that an S corporation is
acquired by a consolidated group.

Additionally, the proposed regulations clarify that 1.1502-76(c)
continues to provide rules for the filing of the separate return for
a corporation's items for the period not included in the
consolidated return. This document also provides notice of a public
hearing on these proposed regulations.

DATES: Written comments must be received by March 10, 1999.

Outlines of topics to be discussed at the public hearing scheduled
for March 31, 1999, at 10 a.m. must be received by March 17, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-106219-98), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to
CC:DOM:CORP:R (REG-106219-98), Courier's Desk, Internal Revenue
Service, 1111 Constitution Avenue, NW., Washington, DC.

Alternatively, taxpayers may submit comments electronically via the
Internet by selecting the "Tax Regs" option on the IRS Home Page, or
by submitting comments directly to the IRS Internet site at:
http://www.irs.ustreas.gov/prod/tax_regs/comments.html. The public
hearing will be held in room 2615, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jeffrey
L. Vogel, (202) 622-7770; concerning submissions, the hearing,
and/or to be placed on the building access list to attend the
hearing, LaNita Van Dyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax
Regulations (26 CFR part 1) under section 1502 of the Internal
Revenue Code of 1986 (the consolidated return regulations). The
amendments apply to acquisitions by a consolidated group of at least
eighty percent of the stock of an S corporation. When a consolidated
group acquires an S corporation, the interaction of the consolidated
return regulations and the subchapter S rules requires the filing of
a separate return for the day of the acquisition. In most
situations, complying with this requirement results in an
unnecessary administrative burden for taxpayers.

The proposed regulations also clarify the impact of the 1994
revisions to 1.1502-76(b) (TD 8560, 1994-2 C.B. 200). The 1994
revisions provided taxpayers greater certainty and prevented
inconsistent allocations of items between a separate and a
consolidated return. The proposed regulations clarify that the due
date for the filing of the separate return for the period not
included in the consolidated return continues to be governed by the
rules in 1.1502-76(c).

Acquisition of an S Corporation

Section 1.1502-76(b)(1)(i) provides that a consolidated return must
include the common parent's items of income, gain, deduction, loss,
and credit for the consolidated return year and each subsidiary's
items for the portion of the year for which the subsidiary is a
member. Generally under 1.1502-76(b)(1)(ii)(A), a subsidiary
becomes a member of the consolidated group at the end of the day on
which its status as a member changes, and its tax year ends at that
time for all Federal income tax purposes.

The subsidiary's items for the period beginning on the day after it
becomes a member of the consolidated group are generally included in
the consolidated return of the group. The subsidiary's items for the
period prior to its becoming a member generally are included in a
separate return.

A small business corporation's election under section 1362(a) to be
an S corporation terminates under section 1362(d)(2) if it ceases to
be a small business corporation. A small business corporation cannot
have a corporate shareholder.

Thus, an S corporation election terminates when the corporation has
another corporation as a shareholder. The termination is effective
on the day the corporation becomes a shareholder. When the
termination of an S corporation election becomes effective on any
day other than the first day of the taxable year, the taxable year
in which the termination occurs is an S termination year under
section 1362(e)(4). The S termination year is comprised of a short
taxable year for which the corporation is an S corporation (the
portion of the S termination year ending on the day before the
terminating event occurs, or S short year) and a short taxable year
for which the corporation is a C corporation (the remainder of the S
termination year, or C short year).

Under section 1362(e)(6)(D), if there is a change in ownership of 50
percent or more of the stock in a corporation during the S
termination year, items of income, gain, loss, deduction, and credit
must be allocated between the S short year and the C short year on
the basis of the corporation's normal method of accounting, as
determined under section 446 (also referred to as a closing of the
corporation's books) as of the close of the S short year, rather
than a daily proration or other method. The S short year and the C
short year are treated as two separate taxable years for most
purposes. Separate returns are required for the S short year and the
C short year, and the due date for the S short year return is the
date by which the C short year return must be filed.

When an S corporation becomes a member of a consolidated group, the
interaction of the consolidated return regulations and the
subchapter S rules results in the corporation having three taxable
periods for the year of the acquisition for which Federal income tax
returns are due: (1) an S short year that ends on the day before the
acquisition by the consolidated group, (2) a C short year consisting
solely of the day of the acquisition, and (3) a short taxable year
(included in the consolidated return) for any items occurring after
the day of the acquisition.

Although three separate taxable periods are created when an S
corporation becomes a member of a consolidated group, existing rules
preclude an allocation of items properly attributable to either the
C short year or the consolidated year to the S short year, for
example, through a daily proration of the items attributable to the
year of the acquisition. Section 1362(e)(6)(D).

The IRS and Treasury have determined that the compliance burdens
associated with filing a separate return for the day that an S
corporation is acquired by a consolidated group are not necessary to
achieve the separate goals of section 1362(e) and the consolidated
return regulations. The proposed regulations will eliminate this
requirement in most situations, while preserving the purpose and
effect of the rules under section 1362(e). These proposed
regulations will not apply, however, if an S corporation becomes a
member of a consolidated group in a qualified stock purchase for
which an election under section 338(g) is made. If the common parent
of the consolidated group and the shareholders of the S corporation
jointly make a section 338(h)(10) election, the administrative
relief provided by these proposed regulations is unnecessary because
the S corporation election of the old target corporation does not
terminate. See 1.338(h)(10)-1(e)(2)(iv).

Under the proposed regulations, an S corporation will become a
member of the consolidated group at the beginning of the day that
includes the acquisition, and its tax year will end for all Federal
income tax purposes at the end of the day preceding the acquisition.
Thus, instead of three short taxable years, the corporation will
have two short taxable years as a result of the acquisition: (1) the
period ending on the day before the S corporation joins the
consolidated group, which will be treated as a taxable year in which
the corporation was an S corporation, and (2) the period during
which the corporation is a member of the consolidated group. The
termination of an S corporation election under section 1362(d)(2)
continues to become effective on the day of the acquisition.
However, because the consolidated return regulations create a
separate taxable year for the corporation, the first day of which is
the day on which the S corporation election terminates, there is no
S termination year within the meaning of section 1362(e)(4).
Consequently, section 1362(e) technically does not apply to the
corporation.

Notwithstanding that there is no there is no S termination year, the
proposed regulations provide rules similar to those that would have
applied under section 1362(e). Under the proposed regulations, as
under section 1362(e)(1)(A), the S corporation's short taxable year
ends at the end of the day preceding the date of the acquisition.
The Federal income tax return for the final taxable year of the S
corporation will be due at the earlier of: (1) the date the S
corporation return would have been due if the taxable year of the S
corporation did not end or (2) the date the consolidated group's
return for the taxable year that includes the acquisition is due.

These proposed regulations also preclude the availability of ratable
allocation under 1.1502-76(b)(2)(ii) and (iii) in order to achieve
the same results that would have obtained if section 1362(e)(6)(D)
had applied. Accordingly, if an S corporation joins a consolidated
group and these proposed regulations apply, then items must be
allocated between the two short taxable years that begin and end
with the corporation joining the consolidated group on the basis of
a closing of the books rather than a ratable allocation of the type
that would have been available under section 1362(e)(2) (in the case
of the termination of an S corporation election) or 1.1502-76(b)(2)
(ii) and (iii) (in the case of a corporation becoming or ceasing to
be a member of a consolidated group).

Due Date for Separate Return

Section 1.1502-76(b) provides guidance regarding the items to be
included in a consolidated return. Items for the portion of a year
not included in the consolidated return must be included in a
separate return.

Section 1.1502-76(b)(1)(ii)(A) provides that a subsidiary becomes
(or ceases to be) a member of the consolidated group at the end of
the day on which its status as a member changes, and its tax year
ends at that time for all Federal income tax purposes. Section
1.1502-76(b)(2)(i) generally provides that the returns that end and
begin with a subsidiary becoming (or ceasing to be) a member of the
consolidated group are subject to the rules of the Internal Revenue
Code applicable to short periods, as if the subsidiary ceased to
exist on becoming a member (or first existed on becoming a
nonmember). Section 1.1502-76(c) provides rules for the filing of
the separate return for the period the subsidiary was not included
in the consolidated group.

The IRS and Treasury are concerned that a broad application of the
provisions of 1.1502-76(b) could be construed to require an
accelerated filing of the separate return by the fifteenth day of
the third month following the end of the short taxable year that
resulted from the corporation joining or leaving the consolidated
group. This interpretation would, in effect, override the provisions
in 1.1502-76(c) concerning the due date for the filing of a
separate return.

The IRS and Treasury did not intend to modify the due date for the
separate return for the period not included in the consolidated
return by the changes in 1.1502-76(b) (as amended by TD 8560). This
proposed regulation clarifies that 1.1502- 76(c) continues to
provide rules for the filing of the separate return.

Proposed Effective Date

The amendments relating to the acquisition of a corporation that,
immediately before becoming a member, had an election under section
1362(a) in effect, are proposed to apply to transactions occurring
after the date final regulations are published in the Federal
Register. The amendments relating to the clarification of the due
date for the separate return for items not included in the return of
a consolidated group are proposed to apply to corporations that
became or ceased to be members of consolidated groups on or after
January 1, 1995, the effective date of the 1994 amendments to
1.1502-76(b).

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 is hereby certified that these regulations will not have a
significant economic impact on a substantial number of small
entities. This certification is based upon the fact that the
proposed regulations will provide administrative relief to small
entities by removing the administrative burden of filing a separate
one-day return currently required for certain acquisitions.
Therefore, a Regulatory Flexibility Analysis under the Regulatory
Flexibility Act (5 U.S.C. chapter 6) 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 Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any comments that are submitted
timely (a signed original and eight (8) copies) to the IRS. All
comments will be made available for public inspection and copying.

A public hearing has been scheduled for March 31, 1999, at 10 a.m.
in room 2615, Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC. Due to building security procedures, visitors
must enter at the 10 Street th entrance, located between
Constitution and Pennsylvania Avenues, NW. In addition, all visitors
must present photo identification to enter the building. Because of
access restrictions, visitors will not be admitted beyond the
immediate entrance area more than 15 minutes before the hearing
starts. For information about having your name placed on the
building access list to attend the hearing, see the "FOR FURTHER
INFORMATION CONTACT" section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must
submit written comments (a signed original and eight (8) copies) by
March 10, 1999. The outline of topics to be discussed and the time
to be devoted to each topic must be received by March 17, 1999.

A period of 10 minutes will be allotted to each person for making
comments.

An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed.

Copies of the agenda will be available free of charge at the
hearing.

Drafting Information

The principal author of these regulations is Jeffrey L.

Vogel of the Office of the 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.

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 1.1502-76 also issued under
26 U.S.C. 1502. * * * Par. 2. Section 1.1362-3 is amended by adding
a sentence to the end of paragraph (a) to read as follows:

1.1362-3 Treatment of S termination year.

(a) In general. * * * See, however, 1.1502- 76(b)(1)(ii)(A)(2) for
special rules for an S election that terminates under section
1362(d) immediately before the S corporation becomes a member of a
consolidated group (within the meaning of 1.1502-1(h)).

* * * * *

Par. 3. Section 1.1502-76 is amended as follows:

1. The text of paragraph (b)(1)(ii)(A) is redesignated as paragraph
(b)(1)(ii)(A)(1).

2. A paragraph heading for newly designated paragraph (b)(1)(ii)(A)
(1) is added.

3. The first sentence of newly designated paragraph (b)(1)(ii)(A)(1)
is revised.

4. Paragraph (b)(1)(ii)(A)(2) is added.

5. Paragraph (b)(2)(v) is redesignated as paragraph (b)(2)(vi).

6. New paragraph (b)(2)(v) is added.

7. Paragraph (b)(5) is redesignated as paragraph (b)(6).

8. Paragraph (b)(4) is redesignated as paragraph (b)(5).

9. New paragraph (b)(4) is added.

10. Newly designated paragraph (b)(5) is amended as follows:.13 a.
The first sentence of paragraph (b)(5), Example 6(b) is revised.

b. The second sentence of paragraph (b)(5), Example 6(c) is revised.

c. Example 7 is added to paragraph (b)(5).

11. Newly designated paragraph (b)(6)(i) is revised.

The revisions and additions read as follows:

1.1502-76 Taxable year of members of group.

* * * * *

(b) * * * (1) * * *

(ii) * * *(A) * * * (1) In general. If a corporation (S), other than
one described in paragraph (b)(1)(ii)(A)(2), becomes or ceases to be
a member during a consolidated return year, it becomes or ceases to
be a member at the end of the day on which its status as a member
changes, and its tax year ends for all Federal income tax purposes
at the end of that day. * * *

(2) Special rule for former S corporations. If S becomes a member in
a transaction other than in a qualified stock purchase for which an
election under section 338(g) is made, and immediately before
becoming a member an election under section 1362(a) was in effect,
then S will become a member at the beginning of the day the
termination of its S corporation election is effective. S's tax year
ends for all Federal income tax purposes at the end of the preceding
day. This paragraph (b)(1)(ii)(A)(2) applies to transactions
occurring after the date that final regulations are published in the
Federal Register.

* * * * *

(2) * * *

(v) Acquisition of S corporation. If a corporation is acquired in a
transaction to which paragraph (b)(1)(ii)(A)(2) of this section
applies, then paragraphs (b)(2)(ii) and (iii) of this section do not
apply and items of income, gain, loss, deduction, and credit are
assigned to each short taxable year on the basis of the
corporation's normal method of accounting as determined under
section 446. This paragraph (b)(2)(v) applies to transactions
occurring after the date that final regulations are published in the
Federal Register.

* * * * *

(4) Determination of due date for separate return.

Paragraph (c) of this section contains rules for the filing of the
separate return referred to in this paragraph (b). In applying
paragraph (c) of this section, the due date for the filing of S's
separate return shall also be determined without regard to the
ending of the tax year under paragraph (b)(1)(ii) of this section or
the deemed cessation of its existence under paragraph (b)(2)(i) of
this section.

* * * * *

(5) * * *

Example 6. Allocation of partnership items. * * * (b) Analysis.
Under paragraph (b)(2)(vi)(A) of this section, T is treated, solely
for purposes of determining T's tax year in which the partnership's
items are included, as selling or exchanging its entire interest in
the partnership as of P's sale of T stock. * * *

(c) Controlled partnership. * * * Under paragraph (b)(2)(vi)(B) of
this section, T's distributive share of the partnership items is
treated as T's items for purposes of paragraph (b)(2) of this
section. * * *

Example 7. Acquisition of S corporation . (a) Facts . Z is a small
business corporation for which an election under section 1362(a) was
in effect at all times since Year 1. At all times, Z had only 100
shares of stock outstanding, all of which were owned by individual
A. On July 1 of Year 3, P acquired all of the Z stock. P does not
make an election under section 338(g) with respect to its purchase
of the Z stock.

(b) Analysis . As a result of P's acquisition of the Z stock, Z's
election under section 1362(a) terminates. See sections 1361(b)(1)
(B) and 1362(d)(2). Z is required to join in the filing of the P
consolidated return. See 1.1502-75. Z's tax year ends for all
Federal income tax purposes on June 30 of Year 3. If no extension of
time is sought, Z must file a separate return for the period from
January 1 through June 30 of Year 3 on or before March 15 of Year 4.
See paragraph (b)(4) of this section. Z will become a member of the
P consolidated group as of July 1 of Year 3. See paragraph (b)(1)
(ii)(A)(2) of this section. P group's Year 3 consolidated return
will include Z's items from July 1 to December 31 of Year 3..(6)
Effective date--(i) General rule. Except as provided in paragraphs
(b)(1)(ii)(A)(2) and (b)(2)(v) of this section, this paragraph (b)
applies to corporations becoming or ceasing to be members of
consolidated groups on or after January 1, 1995.

* * * * *

Deputy Commissioner of Internal Revenue


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