Rev. Rul. 2000-1 TABLE 6 — Internal Revenue Bulletin 2000-2

Deemed Rate of Transfers to New Pooled Income Funds During 2000

Deemed rate of return for transfers during 2000 to pooled income funds that have been in existence for less than 3 taxable years 6.80%

January 10, 2000 252 2000–2 I.R.B.

Explanation of Revisions and Summary of Comments

1. Aggregation of deductions from an S corporation with deductions from other sources.

The proposed regulations provide that a shareholder of an S corporation must aggregate its separate deductions and exclusions with the shareholder’s pro rata share of the S corporation’s separately stated deductions or exclusions in determining the allowable amount of any deduction or exclusion that is subject to a limitation in the Code.

The proposed regulations provide an example of this rule for property expensed under section 179. A commentator suggested that the example implies that a shareholder must expense its pro rata share of section 179 expense from the S corporation before it can expense any separately acquired property.

The example is intended to illustrate that a shareholder may expense only up to the amount allowable under section 179 in any given year regardless of whether the property is owned individually or through an S corporation. The example is not intended to imply that a shareholder must elect to expense property held in an S corporation before it can expense any separately acquired property. However, once an S corporation elects to expense property under section 179, a shareholder will generally elect to expense personal property only to the extent the shareholder’s pro rata share of the corporation’s section 179 expense does not exceed the shareholder’s individual limitation under section 179(b). Accordingly, no modifications have been made to the example in the final regulations.

The commentator also requested that the final regulations provide additional examples that illustrate the aggregation of the shareholder’s pro rata share of deductions and exclusions from an S corporation with deductions and exclusions from other sources and the operation of any limitations on those aggregated deductions and exclusions. Specifically, the commentator requested that the final regulations include an example in which the shareholder’s aggregate section 179 expenses from several passthrough sources exceeds the maximum section 179 expense allowable. The allocation of the section 179 expense among the various

Section 1288.—Treatment of Original Issue Discounts on Tax- Exempt Obligations

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of January 2000. See Rev. Rul. 2000–1, page 250.

Section 1366.—Pass-Thru of Items to Shareholders

26 CFR 1.1366–1: Shareholder’s share of items of an S corporation.

T.D. 8852

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Passthrough of Items of an S Corporation to its Shareholders

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the passthrough of items of an S corporation to its shareholders, the adjustments to the basis of stock of the shareholders, and the treatment of distributions by an S corporation. Changes to the applicable law were made by the Subchapter S Revision Act of 1982, the Tax Reform Act of 1984, the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, and the Small Business Job Protection Act of 1996. These regulations provide the public with guidance needed to comply with the applicable law and will affect S corporations and their shareholders.

DATES: Effective Date : These regulations are effective August 18, 1998.

Applicability Dates : For dates of applicability, see §1.1366-5, §1.1367-3, and §1.1368-4, plus Transition Rule and Effective Date under

SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations under section 1366, Martin Schäffer, Deane M. Burke, or David Shulman (202) 622-3070; concerning the regulations under sections 1367 and 1368, Brenda Stewart, (202) 622-3120.

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507) under control number 1545-1613. Responses to this collection of information are mandatory.

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 burden for this requirement is reflected in the burden of Form 1040, “U.S. Individual Income Tax Return”, and Form 1120S, “U.S. Income Tax Return for an S corporation”.

Suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and 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.

Books or records relating to this 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.

Background

This document amends 26 CFR part 1 to provide additional rules under sections 1366, 1367, and 1368 relating to the passthrough of items of an S corporation to its shareholders, the adjustments to the basis of stock of the shareholders, and the treatment of distributions by an S corporation.

On August 18, 1998, the IRS published in the Federal Register (63 FR 44181), a notice of proposed rulemaking (REG209446-82) regarding sections 1366, 1367, and 1368. Comments responding to the proposed regulations were received. The public hearing was canceled because there were no requests to speak. After considering the comments received, the proposed regulations are adopted as amended by this Treasury decision.

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ment limited the items of loss or deduction. Thus, the carryover is not available to a transferee who acquires the stock whether by sale, death, gift, or otherwise. Accordingly, the final regulations retain the rule that disallowed losses and deductions are nontransferable.

The proposed regulations also provide that if a shareholder transfers all of the shareholder’s stock in the corporation, any disallowed loss or deduction is permanently disallowed. A commentator suggested that the final regulations permit a former shareholder of an S corporation who subsequently reacquires stock in the S corporation to utilize the losses and deductions previously disallowed to the shareholder.

Losses and deductions that are disallowed in any taxable year carry over under section 1366(d) to the succeeding taxable year of the corporation with respect to a particular shareholder. If a shareholder completely terminates its interest in the corporation, the shareholder will not be a shareholder in the succeeding taxable year of the corporation and the disallowed losses would not carry over. There is no statutory authority for the carryover of disallowed items if a shareholder is not a shareholder in the year succeeding the disallowance. The disallowed items of loss and deduction are amounts that exceed the shareholder’s economic investment in the corporation. Once the shareholder terminates its interest in the corporation, it is not necessary to preserve the shareholder’s position in the corporation. Thus, the final regulations do not adopt this commentator’s suggestion. 5. Basis in S corporation stock received as a gift.

Section 1366(d)(1) limits the amount of corporate losses and deductions that can pass through to, and be deducted by, a shareholder to the shareholder’s adjusted basis in the corporation’s stock and debt of the corporation to the shareholder.

The proposed regulations provide that, for purposes of section 1366(d)(1), a shareholder’s basis in stock acquired by gift is the basis of the stock used for purposes of determining loss under section 1015. Thus, if the fair market value of the stock exceeds the donor’s adjusted basis on the date of the gift, for purposes of section 1366(d)(1), the adjusted basis of the stock in the hands of the donee is its ad

sources is more appropriately addressed in the regulations under section 179 and is beyond the scope of these regulations. Accordingly, the final regulations do not adopt this comment. 2. Recharacterization of gains and losses at the shareholder level.

Generally, the items of an S corporation that are passed through, and reported by, a shareholder are characterized at the corporate level in the same manner that partnership items are characterized at the partnership level.

However, the proposed regulations also contain exceptions to this general rule for contributions of either noncapital gain property or capital loss property if an S corporation is formed or availed of by any shareholder or shareholders for a principal purpose of selling or exchanging the property that in the hands of the shareholder or shareholders would have produced a different character of gain or loss. The character of the gain or loss will be the same as it would have been if the property were in the hands of the shareholder or shareholders at the time of the sale or exchange.

Commentators suggested that, in the absence of a statutory provision like section 724 in the partnership context, the IRS lacked the authority to recharacterize gain or loss at the shareholder level. Thus, the commentators asserted that the final regulations should not adopt the recharacterization rules.

Alternatively, the commentators suggested limiting the recharacterization rule to sales or exchanges occurring within a specified time period.

Unlike the partnership rules, the recharacterization rules in the proposed regulations are limited to transactions in which an S corporation is used for a principal purpose of changing the character of the gain or loss of contributed property. These rules are reasonable approaches to remedying any improper attempts to utilize section 1366(b) to avoid tax. The length of time between the contribution of the property to the S corporation and the S corporation’s sale or exchange of the property will be a factor considered in evaluating whether the S corporation was availed of for a principal purpose of changing the character of the gain or loss. However, the final regulations do not adopt any particular time period. Thus,

the final regulations retain the recharacterization rules as proposed. 3. Gross income reporting requirement. Section 1366(c), like section 702(c) in the partnership context, provides for the passthrough of gross income to a shareholder for federal income tax purposes. Thus, where it is necessary to determine the amount or character of the gross income of a shareholder, the proposed regulations provide that a shareholder’s gross income includes the shareholder’s pro rata share of the gross income of the S corporation. This amount is the amount of gross income of the corporation used to derive the shareholder’s pro rata share of S corporation taxable income or loss.

A commentator suggested that the rule in the proposed regulations attempts to narrow the disclosure exception under section 6501(e) by applying a pro rata concept with respect to a shareholder’s gross income. The commentator recommended that the final regulations not adopt the gross income reporting rules or, alternatively, provide a de minimis exception to the rule for certain shareholders who own minority interests in an S corporation.

The rule in the proposed regulations parallels the rules for determining the amount of gross income reported by a partner in a partnership. See section 702(c); §1.702-1(c)(2). Accordingly, the final regulations do not adopt this suggestion. 4. Carryover of disallowed losses under section 1366(d).

Section 1366(d) provides that a shareholder’s disallowed losses and deductions for any taxable year shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder. The proposed regulations provide that a shareholder’s losses and deductions disallowed under section 1366(d) are personal to the shareholder and cannot in any manner be transferred to another person. A commentator requested that the final regulations provide an exception to this rule for transferees that have an identity of investment interest or common basis with the transferor, such as when stock is transferred incident to divorce under section 1041.

Under section 1366(d), the carryover of disallowed losses and deductions is with respect to the shareholder whose invest

January 10, 2000 254 2000–2 I.R.B.

justed basis in the hands of the donor. However, if the donor’s adjusted basis in the stock exceeds the stock’s fair market value on the date of the gift, for purposes of section 1366(d)(1), the adjusted basis of the stock in the hands of the donee is the stock’s fair market value on the date of the gift.

One commentator argued that the basis for determining loss under section 1015 is applicable only on the disposition of the gifted asset. The basis for determining loss in section 1015 generally does not affect the basis for depreciation or the deductibility of net expenses arising out of the use or operation of the gifted asset.

The proposed regulations, however, apply the loss basis rule in section 1015 not for purposes of determining the depreciable basis of a gifted asset, but rather for purposes of determining the amount of passthrough losses and deductions (including depreciation deductions and operating losses) that are allowable to a shareholder under section 1366. The donee of loss stock cannot dispose of the stock and recognize the loss inherent in the stock on the date of gift. If the donee could use the donor’s basis to take depreciation deductions and operating losses of the S corporation, the donee in effect would realize the benefit of the loss inherent in the stock.

Another commentator agreed that the basis for determining loss in section 1015 ought to be the basis of gifted stock for purposes of section 1366. Thus, the final regulations continue to provide that for purposes of section 1366, the basis of stock acquired by gift is the basis for determining loss under section 1015. 6. Allocation of disallowed losses in cer- tain corporate separations.

The proposed regulations provide rules for the carryover of disallowed losses and deductions in the case of certain corporate reorganizations. In the case of an S corporation that transfers a part of its assets constituting an active trade or business to another corporation in a transaction to which section 368(a)(1)(D) applies, and immediately thereafter the stock and securities of the controlled corporation are distributed in a distribution or exchange to which sec

tion 355 (or so much of section 356 as relates to section 355) applies, any disallowed loss or deduction with respect to a shareholder of the distributing corporation immediately before the transaction is allocated between the distributing corporation and the controlled corporation with respect to the shareholder. The proposed regulations provide that the amount of disallowed loss or deduction allocated to the distributing (or controlled) corporation with respect to the shareholder is an amount that bears the same ratio to each item of disallowed loss or deduction as the value of the shareholder’s stock in the distributing (or controlled) corporation bears to the total value of the shareholder’s stock in the distributing and controlled corporations, in each case as determined immediately after the distribution.

A commentator suggested that the term value as used in the proposed regulations is ambiguous and that the final regulations should specifically state “fair market value.” The commentator also recommended that because the computation of fair market value introduces a host of valuation issues into the transaction, the final regulations should permit an allocation of disallowed losses and deductions based on the relative adjusted bases of the assets of the distributing and controlled corporations. Finally, the commentator requested that the final regulations allow S corporations to allocate disallowed losses and deductions to the controlled or distributing corporation based upon the source of those losses and deductions. The final regulations permit shareholders to allocate disallowed losses and deductions according to any reasonable method, including a method based on the relative fair market value of the shareholder’s stock in the distributing and controlled corporations immediately after the distribution, a method based on the relative adjusted bases of the assets in the distributing and controlled corporations immediately after the distribution, or, in the case of losses and deductions clearly attributable to either the distributing or controlled corporation, a method that allocates such losses and deductions accordingly. 7. Allocation of tax on passive invest- ment income under section 1366(f)(3).

Section 1366(f)(3) provides that if any tax is imposed under section 1375 for a taxable year, each item of passive investment income is reduced by an amount which bears the same ratio to the amount of the tax as the amount of the item bears to the total passive investment income for the taxable year.

A commentator requested guidance in the final regulations on whether the allocation of any tax imposed under section 1375 is made based on the total gross or total net passive investment income. Under section 1375, the amount of excess passive investment income is allocated to the items of passive investment income based on the net passive investment income of the corporation. The allocation of the tax imposed on the excess passive investment income should be similarly allocated. Accordingly, the final regulations clarify that the allocation of any tax under section 1375 is based on the total net passive investment income for the taxable year. 8. Accrual of charitable contribution de- ductions under section 170(a)(2).

The proposed regulations under section 1366 provide that each shareholder must take into account the shareholder’s pro rata share of any charitable contributions paid by the corporation during the corporation’s taxable year. A commentator requested that the final regulations clarify that separately stated items include charitable contributions paid or deemed to be paid. The commentator suggested that an accrual basis S corporation may elect under section 170(a)(2) to treat charitable contributions as paid in the year prior to the year in which the charitable contribution is actually paid.

Under section 1363(b), S corporations generally compute their taxable income in the same manner as in the case of an individual. However, S corporations are not permitted to take charitable contribution deductions by virtue of the cross reference in section 1363(b)(2) to section 703(a)(2). Instead, the deductions for charitable contributions pass through to the shareholders of the S corporation. Individuals cannot make the election under section 170(a)(2). Treasury and the Service believe that an S corporation also cannot make the election under section 170(a)(2). Accordingly, the final regulations do not adopt this suggestion.

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9. Treatment of section 108 income The regulations enumerate items of income (including tax-exempt income), loss, deduction, or credit of an S corporation that must be taken into account separately by each shareholder pursuant to section 1366(a)(1)(A). “Tax-exempt income” does not include income from discharge of indebtedness excluded from income under section 108 because such income is not permanently excludible from income in all circumstances in which section 108 applies. One commentator objected to this treatment of section 108 income, arguing that such income is tax-exempt and that application of section 108 at the S corporation level pursuant to section 108(d)(7)(A) does not preclude the pass-through of section 108 income. Another commentator, however, agreed with the approach taken by the regulations.

Treasury and the Service continue to believe that the absence of a stock basis increase for income of an S corporation excluded under section 108(a) is consistent with the legislative history of section 108 and the specific rules that apply to the discharge of indebtedness income of S corporations. Accordingly, the treatment of section 108 income is unchanged in the final regulations. 10. Adjustment to Basis of Stock Section 1367(a) and §1.1367-1 of the proposed regulations prescribe the order of adjustments required by subchapter S to the basis of a shareholder’s stock in an S corporation and the manner in which those adjustments are made.

A commentator suggested that the final regulations should provide that life insurance premiums on policies owned by the S corporation do not affect either a shareholder’s basis in stock/debt or the corporation’s accumulated adjustments account (AAA). The commentator further suggested that §1.1367-1(c)(2) (relating to noncapital, nondeductible expenses) be amended to make special provision for accounts receivable when debt is restored.

Because these comments relate to provisions in §1.1367-1 that were not affected by the amendments contained in the proposed regulations, the comments are not reflected in the final regulations. 11. Adjustments Required Before Deter-

mining Tax Effect of Distribution.

Section 1.1368-2 of the proposed regulations provides rules for determining the source of a distribution made by an S corporation with respect to its stock and the tax effect of the distribution to the shareholders for taxable years of the corporation beginning on or after August 18, 1998.

One commentator interpreted §1.1368-2(a)(5) of the proposed regulations, which prescribes the order in which adjustments are made to the AAA for purposes of determining the source of a distribution, as providing that the AAA is adjusted in the same order as the adjustments to the basis of a share of stock under §1.1367-1 of the proposed regulations. The commentator stated that although the Small Business Job Protection Act of 1996 (1996 Act) changed the order of the adjustments to the basis of a share of stock, the 1996 Act did not change the order of the adjustments to the AAA except in situations involving a net negative adjustment (where the reductions in the account for the taxable year exceed the increases for the taxable year). When a net negative adjustment occurs, the AAA is adjusted to take into account distributions before the AAA is adjusted to take into account any net negative adjustment.

Consistent with the comment received, the final regulations make clear that except in situations involving a net negative adjustment, the order of adjustments to the AAA is not changed. Examples are added to the final regulations to illustrate the effect of the 1996 Act on the AAA ordering rules. 12. Transition Rule and Effective Date sections 1367 and 1368.

Sections 1.1367-3 and 1.1368-4 of the proposed regulations provide that the amendments to the final regulations under section 1367 and 1368 apply only to taxable years of the corporation beginning on or after August 18, 1998.

Commentators suggested that because the amendments to sections 1367 and 1368 under the 1996 Act are effective for taxable years beginning after December 31, 1996, the final regulations should be effective, at least on an elective basis, for the period beginning from the effective date of the 1996 Act and

ending on the effective date of the final regulations.

Sections 1.1367-3 and 1.1368-4 of the final regulations reflect this comment and provide that for taxable years beginning on or after January 1, 1997, and before August 18, 1998, the adjustments to the basis of a shareholder’s stock and the treatment of distributions by an S corporation, respectively, must be determined in a reasonable manner, taking into account the statute and the legislative history. Return positions consistent with the final regulations will be considered reasonable.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 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) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that these regulations do not impose a collection of information that is not already required by the underlying statute or the current regulations and reflected in the appropriate forms. 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, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these final regulations are Terri A. Belanger, Deane M. Burke, and Brenda Stewart of the Office of Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the IRS and Treasury Department participated in their development.

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end of the taxable year of the corporation, the shareholder’s pro rata share of these items is taken into account on the shareholder’s final return. For the limitation on allowance of a shareholder’s pro rata share of S corporation losses or deductions, see section 1366(d) and §1.1366-2.

(2) Separately stated items of income, loss, deduction, or credit. Each shareholder must take into account separately the shareholder’s pro rata share of any item of income (including tax-exempt income), loss, deduction, or credit of the S corporation that if separately taken into account by any shareholder could affect the shareholder’s tax liability for that taxable year differently than if the shareholder did not take the item into account separately. The separately stated items of the S corporation include, but are not limited to, the following items—

(i) The corporation’s combined net amount of gains and losses from sales or exchanges of capital assets grouped by applicable holding periods, by applicable rate of tax under section 1(h), and by any other classification that may be relevant in determining the shareholder’s tax liability;

(ii) The corporation’s combined net amount of gains and losses from sales or exchanges of property described in section 1231 (relating to property used in the trade or business and involuntary conversions), grouped by applicable holding periods, by applicable rate of tax under section 1(h), and by any other classification that may be relevant in determining the shareholder’s tax liability;

(iii) Charitable contributions, grouped by the percentage limitations of section 170(b), paid by the corporation within the taxable year of the corporation;

(iv) The taxes described in section 901 that have been paid (or accrued) by the corporation to foreign countries or to possessions of the United States;

(v) Each of the corporation’s separate items involved in the determination of credits against tax allowable under part IV of subchapter A (section 21 and following) of the Internal Revenue Code, except for any credit allowed under section 34 (relating to certain uses of gasoline and special fuels);

(vi) Each of the corporation’s separate items of gains and losses from wagering transactions (section 165(d)); soil and

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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 * * * Par. 2. Sections 1.1366-0 and 1.1366-1 are added, §1.1366-2 is revised, and §§1.1366-3 through 1.1366-5 are added to read as follows: §1.1366-0 Table of contents.

The following table of contents is provided to facilitate the use of §§1.1366-1 through 1.1366-5:

§1.1366-1 Shareholder’s share of items of an S corporation.

(a) Determination of shareholder’s tax liability. (1) In general. (2) Separately stated items of income, loss, deduction, or credit. (3) Nonseparately computed income or loss. (4) Separate activities requirement. (5) Aggregation of deductions or exclusions for purposes of limitations. (b) Character of items constituting pro rata share. (1) In general. (2) Exception for contribution of noncapital gain property. (3) Exception for contribution of capital loss property. (c) Gross income of a shareholder. (1) In general. (2) Gross income for substantial omission of items. (d) Shareholders holding stock subject to community property laws. (e) Net operating loss deduction of shareholder of S corporation. (f) Cross-reference.

§1.1366-2 Limitations on deduction of passthrough items of an S corporation to its shareholders.

(a) In general. (1) Limitation on losses and deductions. (2) Carryover of disallowance. (3) Basis limitation amount. (i) Stock portion. (ii) Indebtedness portion. (4) Limitation on losses and deductions

allocated to each item. (5) Nontransferability of losses and deductions. (6) Basis of stock acquired by gift. (b) Special rules for carryover of disallowed losses and deductions to post-termination transition period described in section 1377(b). (1) In general. (2) Limitation on losses and deductions. (3) Limitation on losses and deductions allocated to each item. (4) Adjustment to the basis of stock. (c) Carryover of disallowed losses and deductions in the case of liquidations, reorganizations, and divisions. (1) Liquidations and reorganizations. (2) Corporate separations to which section 368(a)(1)(D) applies.

§1.1366-3 Treatment of family groups.

(a) In general. (b) Examples.

§1.1366-4 Special rules limiting the passthrough of certain items of an S cor- poration to its shareholders.

(a) Passthrough inapplicable to section 34 credit. (b) Reduction in passthrough for tax imposed on built-in gains.

§1.1366-5 Effective date. §1.1366-1 Shareholder’s share of items of an S cor- poration.

(a) Determination of shareholder’s tax liability —(1) In general. An S corporation must report, and a shareholder is required to take into account in the shareholder’s return, the shareholder’s pro rata share, whether or not distributed, of the S corporation’s items of income, loss, deduction, or credit described in paragraphs (a)(2), (3), and (4) of this section. A shareholder’s pro rata share is determined in accordance with the provisions of section 1377(a) and the regulations thereunder. The shareholder takes these items into account in determining the shareholder’s taxable income and tax liability for the shareholder’s taxable year with or within which the taxable year of the corporation ends. If the shareholder dies (or if the shareholder is an estate or trust and the estate or trust terminates) before the

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water conservation expenditures (section 175); deduction under an election to expense certain depreciable business expenses (section 179); medical, dental, etc., expenses (section 213); the additional itemized deductions for individuals provided in part VII of subchapter B (section 212 and following) of the Internal Revenue Code; and any other itemized deductions for which the limitations on itemized deductions under sections 67 or 68 applies;

(vii) Any of the corporation’s items of portfolio income or loss, and expenses related thereto, as defined in the regulations under section 469;

(viii) The corporation’s tax-exempt income. For purposes of subchapter S, taxexempt income is income that is permanently excludible from gross income in all circumstances in which the applicable provision of the Internal Revenue Code applies. For example, income that is excludible from gross income under section 101 (certain death benefits) or section 103 (interest on state and local bonds) is taxexempt income, while income that is excludible from gross income under section 108 (income from discharge of indebtedness) or section 109 (improvements by lessee on lessor’s property) is not tax-exempt income;

(ix) The corporation’s adjustments described in sections 56 and 58, and items of tax preference described in section 57; and

(x) Any item identified in guidance (including forms and instructions) issued by the Commissioner as an item required to be separately stated under this paragraph (a)(2).

(3) Nonseparately computed income or loss. Each shareholder must take into account separately the shareholder’s pro rata share of the nonseparately computed income or loss of the S corporation. For this purpose, nonseparately computed income or loss means the corporation’s gross income less the deductions allowed to the corporation under chapter 1 of the Internal Revenue Code, determined by excluding any item requiring separate computation under paragraph (a)(2) of this section.

(4) Separate activities requirement . An S corporation must report, and each shareholder must take into account in the shareholder’s return, the shareholder’s

pro rata share of an S corporation’s items of income, loss, deduction, or credit described in paragraphs (a)(2) and (3) of this section for each of the corporation’s activities as defined in section 469 and the regulations thereunder.

(5) Aggregation of deductions or exclu- sions for purposes of limitations —(i) In general. A shareholder aggregates the shareholder’s separate deductions or exclusions with the shareholder’s pro rata share of the S corporation’s separately stated deductions or exclusions in determining the amount of any deduction or exclusion allowable to the shareholder under subtitle A of the Internal Revenue Code as to which a limitation is imposed.

(ii) Example . The provisions of paragraph (a)(5)(i) of this section are illustrated by the following example:

Example . In 1999, Corporation M, a calendar year S corporation, purchases and places in service section 179 property costing $10,000. Corporation M elects to expense the entire cost of the property. Shareholder A owns 50 percent of the stock of Corporation M. Shareholder A’s pro rata share of this item after Corporation M applies the section 179(b) limitations is $5,000. Because the aggregate amount of Shareholder A’s pro rata share and separately acquired section 179 expense may not exceed $19,000 (the aggregate maximum cost that may be taken into account under section 179(a) for the applicable taxable year), Shareholder A may elect to expense up to $14,000 of separately acquired section 179 property that is purchased and placed in service in 1999, subject to the limitations of section 179(b).

(b) Character of items constituting pro rata share —(1) In general . Except as provided in paragraph (b)(2) or (3) of this section, the character of any item of income, loss, deduction, or credit described in section 1366(a)(1)(A) or (B) and paragraph (a) of this section is determined for the S corporation and retains that character in the hands of the shareholder. For example, if an S corporation has capital gain on the sale or exchange of a capital asset, a shareholder’s pro rata share of that gain will also be characterized as a capital gain regardless of whether the shareholder is otherwise a dealer in that type of property. Similarly, if an S corporation engages in an activity that is not for profit (as defined in section 183), a shareholder’s pro rata share of the S corporation’s deductions will be characterized as not for profit. Also, if an S corporation makes a charitable contribution to an or

ganization qualifying under section 170(b)(1)(A), a shareholder’s pro rata share of the S corporation’s charitable contribution will be characterized as made to an organization qualifying under section 170(b)(1)(A).

(2) Exception for contribution of non- capital gain property . If an S corporation is formed or availed of by any shareholder or group of shareholders for a principal purpose of selling or exchanging contributed property that in the hands of the shareholder or shareholders would not have produced capital gain if sold or exchanged by the shareholder or shareholders, then the gain on the sale or exchange of the property recognized by the corporation is not treated as a capital gain.

(3) Exception for contribution of cap- ital loss property. If an S corporation is formed or availed of by any shareholder or group of shareholders for a principal purpose of selling or exchanging contributed property that in the hands of the shareholder or shareholders would have produced capital loss if sold or exchanged by the shareholder or shareholders, then the loss on the sale or exchange of the property recognized by the corporation is treated as a capital loss to the extent that, immediately before the contribution, the adjusted basis of the property in the hands of the shareholder or shareholders exceeded the fair market value of the property.

(c) Gross income of a shareholder —(1) In genera l. Where it is necessary to de- termine the amount or character of the gross income of a shareholder, the shareholder’s gross income includes the shareholder’s pro rata share of the gross income of the S corporation. The shareholder’s pro rata share of the gross income of the S corporation is the amount of gross income of the corporation used in deriving the shareholder’s pro rata share of S corporation taxable income or loss (including items described in section 1366(a)(1)(A) or (B) and paragraph (a) of this section). For example, a shareholder is required to include the shareholder’s pro rata share of S corporation gross income in computing the shareholder’s gross income for the purposes of determining the necessity of filing a return (section 6012(a)) and the shareholder’s gross income derived from farming (sections 175 and 6654(i)).

January 10, 2000 258 2000–2 I.R.B.

this section (limiting losses and deductions) by taking into account only increases in basis under section 1367(a)(1) for the taxable year and decreases in basis under section 1367(a)(2)(A), (D) and (E) (relating to distributions, noncapital, nondeductible expenses, and certain oil and gas depletion deductions) for the taxable year. In so determining this loss limitation amount, the shareholder disregards decreases in basis under section 1367(a)(2)(B) and (C) (for losses and deductions, including losses and deductions previously disallowed) for the taxable year. However, if the shareholder has in effect for the taxable year an election under §1.1367-1(g) to decrease basis by items of loss and deduction prior to decreasing basis by noncapital, nondeductible expenses and certain oil and gas depletion deductions, the shareholder also disregards decreases in basis under section 1367(a)(2)(D) and (E). This basis limitation amount for stock is determined at the time prescribed under §1.13671(d)(1) for adjustments to the basis of stock.

(ii) Indebtedness portion . A shareholder determines the shareholder’s adjusted basis in indebtedness of the corporation for purposes of paragraphs (a)(1)(ii) and (2) of this section (limiting losses and deductions) without regard to any adjustment under section 1367(b)(2)(A) for the taxable year. This basis limitation amount for indebtedness is determined at the time prescribed under §1.1367-2(d)(1) for adjustments to the basis of indebtedness.

(4) Limitation on losses and deductions allocated to each item. If a shareholder’s pro rata share of the aggregate amount of losses and deductions specified in §1.1366-1(a)(2), (3), and (4) exceeds the sum of the adjusted basis of the shareholder’s stock in the corporation (determined in accordance with paragraph (a)(3)(i) of this section) and the adjusted basis of any indebtedness of the corporation to the shareholder (determined in accordance with paragraph (a)(3)(ii) of this section), then the limitation on losses and deductions under section 1366(d)(1) must be allocated among the shareholder’s pro rata share of each loss or deduction. The amount of the limitation allocated to any loss or deduction is an amount that bears the same ratio to the amount of the limita

(2) Gross income for substantial omis- sion of items —(i) In general. For purposes of determining the applicability of the 6- year period of limitation on assessment and collection provided in section 6501(e) (relating to omission of more than 25 percent of gross income), a shareholder’s gross income includes the shareholder’s pro rata share of S corporation gross income (as described in section 6501(e)(1)(A)(i)). In this respect, the amount of S corporation gross income used in deriving the shareholder’s pro rata share of any item of S corporation income, loss, deduction, or credit (as included or disclosed in the shareholder’s return) is considered as an amount of gross income stated in the shareholder’s return for purposes of section 6501(e).

(ii) Example . The following example illustrates the provisions of paragraph (c)(2)(i) of this section:

Example. Shareholder A, an individual, owns 25 percent of the stock of Corporation N, an S corporation that has $10,000 gross income and $2,000 taxable income. A reports only $300 as A’s pro rata share of N’s taxable income. A should have reported $500 as A’s pro rata share of taxable income, derived from A’s pro rata share, $2,500, of N’s gross income. Because A’s return included only $300 without a disclosure meeting the requirements of section 6501(e)(1)(A)(ii) describing the difference of $200, A is regarded as having reported on the return only $1,500 ($300/$500 of $2,500) as gross income from N.

(d) Shareholders holding stock subject to community property laws. If a shareholder holds S corporation stock that is community property, then the shareholder’s pro rata share of any item or items listed in paragraphs (a)(2), (3), and (4) of this section with respect to that stock is reported by the husband and wife in accordance with community property rules.

(e) Net operating loss deduction of shareholder of S corporation. For purposes of determining a net operating loss deduction under section 172, a shareholder of an S corporation must take into account the shareholder’s pro rata share of items of income, loss, deduction, or credit of the corporation. See section 1366(b) and paragraph (b) of this section for rules on determining the character of the items. In determining under section 172(d)(4) the nonbusiness deductions allowable to a shareholder of an S corporation (arising from both corporation

sources and any other sources), the shareholder separately takes into account the shareholder’s pro rata share of the deductions of the corporation that are not attributable to a trade or business and combines this amount with the shareholder’s nonbusiness deductions from any other sources. The shareholder also separately takes into account the shareholder’s pro rata share of the gross income of the corporation not derived from a trade or business and combines this amount with the shareholder’s nonbusiness income from all other sources. See section 172 and the regulations thereunder.

(f) Cross-reference . For rules relating to the consistent tax treatment of subchapter S items, see section 6037(c). §1.1366-2 Limitations on deduction of passthrough items of an S corporation to its shareholders.

(a) In general —(1) Limitation on losses and deductions. The aggregate amount of losses and deductions taken into account by a shareholder under §1.1366-1(a)(2), (3), and (4) for any taxable year of an S corporation cannot exceed the sum of—

(i) The adjusted basis of the shareholder’s stock in the corporation (as determined under paragraph (a)(3)(i) of this section); and

(ii) The adjusted basis of any indebtedness of the corporation to the shareholder (as determined under paragraph (a)(3)(ii) of this section).

(2) Carryover of disallowance. A shareholder’s aggregate amount of losses and deductions for a taxable year in excess of the sum of the adjusted basis of the shareholder’s stock in an S corporation and of any indebtedness of the S corporation to the shareholder is not allowed for the taxable year. However, any disallowed loss or deduction retains its character and is treated as incurred by the corporation in the corporation’s first succeeding taxable year, and subsequent taxable years, with respect to the shareholder. For rules on determining the adjusted bases of stock of an S corporation and indebtedness of the corporation to the shareholder, see paragraphs (a)(3)(i) and (ii) of this section.

(3) Basis limitation amount —(i) Stock portion . A shareholder generally determines the adjusted basis of stock for purposes of paragraphs (a)(1)(i) and (2) of

2000–2 I.R.B. 259 January 10, 2000

tion as the loss or deduction bears to the total of the losses and deductions. For this purpose, the total of losses and deductions for the taxable year is the sum of the shareholder’s pro rata share of losses and deductions for the taxable year, and the losses and deductions disallowed and carried forward from prior years pursuant to section 1366(d)(2).

(5) Nontransferability of losses and de- ductions. Any loss or deduction disallowed under paragraph (a)(1) of this section is personal to the shareholder and cannot in any manner be transferred to another person. If a shareholder transfers some but not all of the shareholder’s stock in the corporation, the amount of any disallowed loss or deduction under this section is not reduced and the transferee does not acquire any portion of the disallowed loss or deduction. If a shareholder transfers all of the shareholder’s stock in the corporation, any disallowed loss or deduction is permanently disallowed.

(6) Basis of stock acquired by gift. For purposes of section 1366(d)(1)(A) and paragraphs (a)(1)(i) and (2) of this section, the basis of stock in a corporation acquired by gift is the basis of the stock that is used for purposes of determining loss under section 1015(a).

(b) Special rules for carryover of disal- lowed losses and deductions to post-ter- mination transition period described in section 1377(b) —(1) In general . If, for the last taxable year of a corporation for which it was an S corporation, a loss or deduction was disallowed to a shareholder by reason of the limitation in paragraph (a) of this section, the loss or deduction is treated under section 1366(d)(3) as incurred by that shareholder on the last day of any post-termination transition period (within the meaning of section 1377(b)).

(2) Limitation on losses and deduc- tions . The aggregate amount of losses and deductions taken into account by a shareholder under paragraph (b)(1) of this section cannot exceed the adjusted basis of the shareholder’s stock in the corporation determined at the close of the last day of the post-termination transition period. For this purpose, the adjusted basis of a shareholder’s stock in the corporation is determined at the close of the last day of the post-termination transition period without regard to any reduction required

under paragraph (b)(4) of this section. If a shareholder disposes of a share of stock prior to the close of the last day of the post-termination transition period, the adjusted basis of that share is its basis as of the close of the day of disposition. Any losses and deductions in excess of a shareholder’s adjusted stock basis are permanently disallowed. For purposes of section 1366(d)(3)(B) and this paragraph (b)(2), the basis of stock in a corporation acquired by gift is the basis of the stock that is used for purposes of determining loss under section 1015(a).

(3) Limitation on losses and deductions allocated to each item. If the aggregate amount of losses and deductions treated as incurred by the shareholder under paragraph (b)(1) of this section exceeds the adjusted basis of the shareholder’s stock determined under paragraph (b)(2) of this section, the limitation on losses and deductions under section 1366(d)(3)(B) must be allocated among each loss or deduction. The amount of the limitation allocated to each loss or deduction is an amount that bears the same ratio to the amount of the limitation as the amount of each loss or deduction bears to the total of all the losses and deductions.

(4) Adjustment to the basis of stock. The shareholder’s basis in the stock of the corporation is reduced by the amount allowed as a deduction by reason of this paragraph (b). For rules regarding adjustments to the basis of a shareholder’s stock in an S corporation, see §1.1367-1.

(c) Carryover of disallowed losses and deductions in the case of liquidations, re- organizations, and divisions —(1) Liqui- dations and reorganizations. If a corporation acquires the assets of an S corporation in a transaction to which section 381(a) applies, any loss or deduction disallowed under paragraph (a) of this section with respect to a shareholder of the distributor or transferor S corporation is available to that shareholder as a shareholder of the acquiring corporation. Thus, where the acquiring corporation is an S corporation, a loss or deduction of a shareholder of the distributor or transferor S corporation disallowed prior to or during the taxable year of the transaction is treated as incurred by the acquiring S corporation with respect to that shareholder if the shareholder is a shareholder of the acquiring S corporation after the transac

tion. Where the acquiring corporation is a C corporation, a post-termination transition period arises the day after the last day that an S corporation was in existence and the rules provided in paragraph (b) of this section apply with respect to any shareholder of the acquired S corporation that is also a shareholder of the acquiring C corporation after the transaction. See the special rules under section 1377 for the availability of the post-termination transition period if the acquiring corporation is a C corporation.

(2) Corporate separations to which section 368(a)(1)(D) applies . If an S corporation transfers a portion of its assets constituting an active trade or business to another corporation in a transaction to which section 368(a)(1)(D) applies, and immediately thereafter the stock and securities of the controlled corporation are distributed in a distribution or exchange to which section 355 (or so much of section 356 as relates to section 355) applies, any loss or deduction disallowed under paragraph (a) of this section with respect to a shareholder of the distributing S corporation immediately before the transaction is allocated between the distributing corporation and the controlled corporation with respect to the shareholder. Such allocation shall be made according to any reasonable method, including a method based on the relative fair market value of the shareholder’s stock in the distributing and controlled corporations immediately after the distribution, a method based on the relative adjusted basis of the assets in the distributing and controlled corporations immediately after the distribution, or, in the case of losses and deductions clearly attributable to either the distributing or controlled corporation, any method that allocates such losses and deductions accordingly. §1.1366-3 Treatment of family groups.

(a) In general. Under section 1366(e), if an individual, who is a member of the family of one or more shareholders of an S corporation, renders services for, or furnishes capital to, the corporation without receiving reasonable compensation, the Commissioner shall prescribe adjustments to those items taken into account by the individual and the shareholders as may be necessary to reflect the value of the services rendered or capital furnished. For these purposes, in determining the

January 10, 2000 260 2000–2 I.R.B.

reasonable value for services rendered, or capital furnished, to the corporation, consideration will be given to all the facts and circumstances, including the amount that ordinarily would be paid in order to obtain comparable services or capital from a person (other than a member of the family) who is not a shareholder in the corporation. In addition, for purposes of section 1366(e), if a member of the family of one or more shareholders of the S corporation holds an interest in a passthrough entity (e.g., a partnership, S corporation, trust, or estate), that performs services for, or furnishes capital to, the S corporation without receiving reasonable compensation, the Commissioner shall prescribe adjustments to the passthrough entity and the corporation as may be necessary to reflect the value of the services rendered or capital furnished. For purposes of section 1366(e), the term family of any shareholder includes only the shareholder’s spouse, ancestors, lineal descendants, and any trust for the primary benefit of any of these persons.

(b) Examples. The provisions of this section may be illustrated by the following examples:

Example 1 . The stock of an S corporation is owned 50 percent by F and 50 percent by T, the minor son of F. For the taxable year, the corporation has items of taxable income equal to $70,000. Compensation of $10,000 is paid by the corporation to F for services rendered during the taxable year, and no compensation is paid to T, who rendered no services. Based on all the relevant facts and circumstances, reasonable compensation for the services rendered by F would be $30,000. In the discretion of the Internal Revenue Service, up to an additional $20,000 of the $70,000 of the corporation’s taxable income, for tax purposes, may be allocated to F as compensation for services rendered. If the Internal Revenue Service allocates $20,000 of the corporation’s taxable income to F as compensation for services, taxable income of the corporation would be reduced by $20,000 to $50,000, of which F and T each would be allocated $25,000. F would have $30,000 of total compensation paid by the corporation for services rendered.

Example 2 . The stock of an S corporation is owned by A and B. For the taxable year, the corporation has paid compensation to a partnership that rendered services to the corporation during the taxable year. The spouse of A is a partner in that partnership. Consequently, if based on all the relevant facts and circumstances the partnership did not receive reasonable compensation for the services ren

dered to the corporation, the Internal Revenue Service, in its discretion, may make adjustments to those items taken into account by the partnership and the corporation as may be necessary to reflect the value of the services rendered. §1.1366-4 Special rules limiting the passthrough of certain items of an S cor- poration to its shareholders.

(a) Passthrough inapplicable to section 34 credit. Section 1.1366-1(a) does not apply to any credit allowable under section 34 (relating to certain uses of gasoline and special fuels).

(b) Reduction in passthrough for tax imposed on built-in gains. For purposes of §1.1366-1(a), if for any taxable year of the S corporation a tax is imposed on the corporation under section 1374, the amount of the tax imposed is treated as a loss sustained by the S corporation during the taxable year. The character of the deemed loss is determined by allocating the loss proportionately among the net recognized built-in gains giving rise to the tax and attributing the character of each net recognized built-in gain to the allocable portion of the loss.

(c) Reduction in passthrough for tax imposed on excess net passive income. For purposes of §1.1366-1(a), if for any taxable year of the S corporation a tax is imposed on the corporation under section 1375, each item of passive investment income shall be reduced by an amount that bears the same ratio to the amount of the tax as the amount of the item bears to the total net passive investment income for that taxable year. §1.1366-5 Effective date.

Sections 1.1366-1 through 1.1366-4 apply to taxable years of an S corporation beginning on or after August 18, 1998.

Par. 3. Section 1.1367-0 is amended in the table as follows:

The entries for §1.1367-1(e) through (g) are revised.
The entries for §1.1367-1(h) through (j) are added.

The additions and revisions read as follows: §1.1367-0 Table of contents.

§1.1367-1 Adjustments to basis of share- holder’s stock in an S corporation.

(e) Ordering rules for taxable years beginning before January 1, 1997. (f) Ordering rules for taxable years begin

ning on or after August 18, 1998. (g) Elective ordering rule. (h) Examples. (i) [Reserved] (j) Adjustments for items of income in respect of a decedent.

Par. 4. Section 1.1367-1 is amended as follows:

The paragraph heading and introductory text of paragraph (e) are revised.
Paragraphs (f) and (g) are redesignated as paragraphs (g) and (h), respectively.
New paragraph (f) is added.
The first and second sentences of newly designated paragraph (g) are revised.
Newly designated paragraph (h) is amended as follows:

a. The heading for Example 1 is revised.

b. Example 2 and Example 3 are redesignated as Example 3 and Example 4, respectively.

c. New Example 2 is added. d. The heading of newly designated Example 4 is revised.

e. Example 5 is added. 6. Paragraph (i) is added and reserved and paragraph (j) is added.

The additions and revisions read as follows: §1.1367-1 Adjustments to basis of share- holder’s stock in an S corporation.

(e) Ordering rules for taxable years be- ginning before January 1, 1997 . For any taxable year of a corporation beginning before January 1, 1997, except as provided in paragraph (g) of this section, the adjustments required by section 1367(a) are made in the following order—

(f) Ordering rules for taxable years be- ginning on or after August 18, 1998. For any taxable year of a corporation beginning on or after August 18, 1998, except as provided in paragraph (g) of this section, the adjustments required by section 1367(a) are made in the following order—

(1) Any increase in basis attributable to the income items described in section 1367(a)(1)(A) and (B), and the excess of the deductions for depletion described in section 1367(a)(1)(C);

2000–2 I.R.B. 261 January 10, 2000

(2) Any decrease in basis attributable to a distribution by the corporation described in section 1367(a)(2)(A);

(3) Any decrease in basis attributable to noncapital, nondeductible expenses described in section 1367(a)(2)(D), and the oil and gas depletion deduction described in section 1367(a)(2)(E); and

(4) Any decrease in basis attributable to items of loss or deduction described in section 1367(a)(2)(B) and (C).

(g) Elective ordering rule. A shareholder may elect to decrease basis under paragraph (e)(3) or (f)(4) of this section, whichever applies, prior to decreasing basis under paragraph (e)(2) or (f)(3) of this section, whichever applies. If a shareholder makes this election, any amount described in paragraph (e)(2) or (f)(3) of this section, whichever applies, that is in excess of the shareholder’s basis in stock and indebtedness is treated, solely for purposes of this section, as an amount described in paragraph (e)(2) or (f)(3) of this section, whichever applies, in the succeeding taxable year. * * *

(h) * * * Example 1. Adjustments to basis of stock for tax- able years beginning before January 1, 1997. - * *

Example 2. Adjustments to basis of stock for tax- able years beginning on or after August 18, 1998. (i) On December 31, 2001, A owns a block of 50 shares of stock with an adjusted basis per share of $6 in Corporation S. On December 31, 2001, A purchases for $400 an additional block of 50 shares of stock with an adjusted basis of $8 per share. Thus, A holds 100 shares of stock for each day of the 2002 taxable year. For S’s 2002 taxable year, A’s pro rata share of the amount of items described in section 1367(a)(1)(A) (relating to increases in basis of stock) is $300, A’s pro rata share of the amount of the items described in section 1367(a)(2)(B) (relating to decreases in basis of stock attributable to items of loss and deduction) is $300, and A’s pro rata share of the amount of the items described in section 1367(a)(2)(D) (relating to decreases in basis of stock attributable to noncapital, nondeductible expenses) is $200. S makes a distribution to A in the amount of $100 during 2002.

(ii) Pursuant to the ordering rules of paragraph (f) of this section, A first increases the basis of each share of stock by $3 ($300/100 shares) and then decreases the basis of each share by $1 ($100/100 shares) for the distribution. A next decreases the basis of each share by $2 ($200/100 shares) for the noncapital, nondeductible expenses and then decreases the basis of each share by $3 ($300/100 shares) for the items of loss. Thus, on January 1,

2003, A has a basis of $3 per share in the original block of 50 shares ($6 + $3 - $1 - $2 - $3) and a basis of $5 per share in the second block of 100 shares ($8 + $3 - $1 - $2 - $3).

Example 4. Effects of section 1377(a)(2) election and distribution on basis of stock for taxable years beginning before January 1, 1997. - * *

Example 5. Effects of section 1377(a)(2) election and distribution on basis of stock for taxable years beginning on or after August 18, 1998. (i) The facts are the same as in Example 4, except that all of the events occur in 2001 rather than in 1994 and except as follows: On June 30, 2001, B sells 25 shares of her stock for $5,000 to D and 25 shares back to Corporation S for $5,000. Under section 1377(a)(2)(B) and §1.1377-1(b)(2), B and C are affected shareholders because B has transferred shares to Corporation S. Pursuant to section 1377(a)(2)(A) and §1.1377-1(b)(1), B and C, the affected shareholders, and Corporation S agree to treat the taxable year 2001 as if it consisted of two separate taxable years for all affected shareholders for the purposes set forth in §1.1377-1(b)(3)(i).

(ii) On June 30, 2001, B and C, pursuant to the ordering rules of paragraph (f)(1) of this section, increase the basis of each share by $60 ($6,000/100 shares) for the nonseparately computed income. Then B and C reduce the basis of each share by $120 ($12,000/100 shares) for the distribution. Finally, B and C decrease the basis of each share by $40 ($4,000/100 shares) for the separately stated deduction item.

(iii) The basis of the stock of B is reduced from $120 to $20 per share ($120 + $60 - $120 - $40). Prior to accounting for the separately stated deduction item, the basis of the stock of C is reduced from $80 to $20 ($80 + $60 - $120). Finally, because the period from January 1 through June 30, 2001 is treated under §1.1377-1(b)(3)(i) as a separate taxable year for purposes of making adjustments to the basis of stock, under section 1366(d) and §1.13662(a)(2), C may deduct only $20 per share of the remaining $40 of the separately stated deduction item, and the basis of the stock of C is reduced from $20 per share to $0 per share. Under section 1366 and §1.1366-2(a)(2), C’s remaining separately stated deduction item of $20 per share is treated as having been incurred in the first succeeding taxable year of Corporation S, which, for this purpose, begins on July 1, 2001.

(i) [Reserved] (j) Adjustments for items of income in respect of a decedent. The basis determined under section 1014 of any stock in an S corporation is reduced by the portion of the value of the stock that is attributable to items constituting income in re

spect of a decedent. For the determination of items realized by an S corporation constituting income in respect of a decedent, see sections 1367(b)(4)(A) and 691 and applicable regulations thereunder. For the determination of the allowance of a deduction for the amount of estate tax attributable to income in respect of a decedent, see section 691(c) and applicable regulations thereunder.

Par. 5. §1.1367-3 is revised to read as follows: §1.1367-3 Effective date and transition rule.

Except for §1.1367-1(f), (h) Example 2 and Example 5, and (j), §§1.1367-1 and 1.1367-2 apply to taxable years of the corporation beginning on or after January 1, 1994. Section 1.1367-1(f), (h) Exam- ple 2 and Example 5, and (j) apply only to taxable years of the corporation beginning on or after August 18, 1998. For taxable years beginning before January 1, 1994, and taxable years beginning on or after January 1, 1997, and before August 18, 1998, the basis of a shareholder’s stock must be determined in a reasonable manner, taking into account the statute and legislative history. Except for §1.13671(f), (h) Example 2 and Example 5, and (j), return positions consistent with §§1.1367-1 and 1.1367-2 are reasonable for taxable years beginning before January 1, 1994. Return positions consistent with §1.1367-1(f), (h) Example 2 and Ex- ample 5, and (j) are reasonable for taxable years beginning on or after January 1, 1997, and before August 18, 1998. Par. 6. Section 1.1368-0 is amended in the table as follows:

The entry for §1.1368-1(e) is revised and entries for §1.1368-1(e)(1) and (2) are added.
The entry for §1.1368-2(a)(4) is revised.
An entry for §1.1368-2(a)(5) is added.
The entry for §1.1368-2(d) is revised.

The additions and revisions read as follows: §1.1368-0 Table of contents.

§1.1368-1 Distributions by S corpora- tions.

(e) Certain adjustments taken into account.

January 10, 2000 262 2000–2 I.R.B.

(1) Taxable years beginning before January 1, 1997. (2) Taxable years beginning on or after August 18, 1998.

§1.1368-2 Accumulated adjustments ac- count (AAA). (a) * * * (4) Ordering rules for the AAA for taxable years beginning before January 1, 1997. (5) Ordering rules for the AAA for taxable years beginning on or after August 18, 1998.

(d) Adjustment in the case of redemptions, liquidations, reorganizations, and divisions.

Par. 7. Section 1.1368-1 is amended by revising paragraphs (d)(1) and (e) to read as follows: §1.1368-1 Distributions by S corpora- tions.

(d) S corporation with earnings and profits —(1) General treatment of distrib- ution. Except as provided in paragraph (d)(2) of this section, a distribution made with respect to its stock by an S corporation that has accumulated earnings and profits as of the end of the taxable year of the S corporation in which the distribution is made is treated in the manner provided in section 1368(c). See section 316 and §1.316-2 for provisions relating to the allocation of earnings and profits among distributions.

(e) Certain adjustments taken into ac- count —(1) Taxable years beginning be- fore January 1, 1997 . For any taxable year of the corporation beginning before January 1, 1997, paragraphs (c) and (d) of this section are applied only after taking into account—

(i) The adjustments to the basis of the shares of a shareholder’s stock described in section 1367 (without regard to section 1367(a)(2)(A) (relating to decreases attributable to distributions not includible in income)) for the S corporation’s taxable year; and

(ii) The adjustments to the AAA required by section 1368(e)(1)(A) (but without regard to the adjustments for distributions under §1.1368-2(a)(3)(iii)) for the S corporation’s taxable year.

(2) Taxable years beginning on or after

August 18, 1998 . For any taxable year of the corporation beginning on or after August 18, 1998, paragraphs (c) and (d) of this section are applied only after taking into account—

(i) The adjustments to the basis of the shares of a shareholder’s stock described in section 1367(a)(1) (relating to increases in basis of stock) for the S corporation’s taxable year; and

(ii) The adjustments to the AAA required by section 1368(e)(1)(A) (but without regard to the adjustments for distributions under §1.1368-2(a)(3)(iii)) for the S corporation’s taxable year. Any net negative adjustment (as defined in section 1368(e)(1)(C)(ii)) for the taxable year shall not be taken into account.

Par. 8. Section 1.1368-2 is amended as follows:

Paragraphs (a)(1) and (a)(3)(ii), and the paragraph heading and introductory text of paragraph (a)(4) are revised.
Paragraph (a)(5) is added.
The paragraph heading for paragraph (d) is revised.

The additions and revisions read as follows: §1.1368-2 Accumulated adjustments ac- count (AAA).

(a) Accumulated adjustments account —(1) In general . The accumulated adjustments account is an account of the S corporation and is not apportioned among shareholders. The AAA is relevant for all taxable years beginning on or after January 1, 1983, for which the corporation is an S corporation. On the first day of the first year for which the corporation is an S corporation, the balance of the AAA is zero. The AAA is increased in the manner provided in paragraph (a)(2) of this section and is decreased in the manner provided in paragraph (a)(3) of this section. For the adjustments to the AAA in the case of redemptions, liquidations, reorganizations, and corporate separations, see paragraph (d) of this section.

(3) * * *

(ii) Extent of allowable reduction . The AAA may be decreased under paragraph (a)(3)(i) of this section below zero. The AAA is decreased by noncapital, nondeductible expenses under paragraph (a)(3)(i)(C) of this section even though a portion of the noncapital, nondeductible

expenses is not taken into account by a shareholder under §1.1367-1(g) (relating to the elective ordering rule). The AAA is also decreased by the entire amount of any loss or deduction even though a portion of the loss or deduction is not taken into account by a shareholder under section 1366(d)(1) or is otherwise not currently deductible under the Internal Revenue Code. However, in any subsequent taxable year in which the loss, deduction, or noncapital, nondeductible expense is treated as incurred by the corporation with respect to the shareholder under section 1366(d)(2) or §1.1367-1(g) (or in which the loss or deduction is otherwise allowed to the shareholder), no further adjustment is made to the AAA.

(4) Ordering rules for the AAA for tax- able years beginning before January 1, 1997. For any taxable year beginning before January 1, 1997, the adjustments to the AAA are made in the following order—

(5) Ordering rules for the AAA for tax- able years beginning on or after August 18, 1998. For any taxable year of the S corporation beginning on or after August 18, 1998, the adjustments to the AAA are made in the following order—

(i) The AAA is increased under paragraph (a)(2) of this section before it is decreased under paragraph (a)(3)(i) of this section for the taxable year;

(ii) The AAA is decreased under paragraph (a)(3)(i) of this section (without taking into account any net negative adjustment (as defined in section 1368(e)(1)(C)(ii)) before it is decreased under paragraph (a)(3)(iii) of this section;

(iii) The AAA is decreased (but not below zero) by any portion of an ordinary distribution to which section 1368(b) or (c)(1) applies;

(iv) The AAA is decreased by any net negative adjustment (as defined in section 1368(e)(1)(C)(ii)); and (v) The AAA is adjusted (whether negative or positive) for redemption distributions under paragraph (d)(1) of this section.

(d) Adjustment in the case of redemp- tions, liquidations, reorganizations, and divisions - * *

2000–2 I.R.B. 263 January 10, 2000

Par. 9. Section 1368-3 is amended as follows:

The heading for Example 1 is revised.
Example 3 through Example 6 are redesignated as Example 6 through Exam- ple 9, respectively.
Example 2 is redesignated as Exam- ple 3 .
The heading for newly redesignated Example 3 is revised.
New Example 2, Example 4, and Ex- ample 5 are added.

The revisions and additions read as follows: §1.1368-3 Examples.

Example 1. Distributions by S corporations without C corporation earnings and profits for tax- able years beginning before January 1, 1997. - * *

Example 2. Distributions by S corporations without earnings and profits for taxable years begin- ning on or after August 18, 1998. (i) Corporation S, an S corporation, has no earnings and profits as of January 1, 2001, the first day of its 2001 taxable year. S’s sole shareholder, A, holds 10 shares of S stock with a basis of $1 per share as of that date. On March 1, 2001, S makes a distribution of $38 to A. The balance in Corporation S’s AAA is $100. For S’s 2001 taxable year, A’s pro rata share of the amount of the items described in section 1367(a)(1) (relating to increases in basis of stock) is $50. A’s pro rata share of the amount of the items described in sections 1367(a)(2)(B) through (D) (relating to decreases in basis of stock for items other than distributions) is $26, $20 of which is attributable to items described in section 1367(a)(2)(B) and (C) and $6 of which is attributable to items described in section 1367(a)(2)(D) (relating to decreases in basis attributable to noncapital, nondeductible expenses).

(ii) Under section 1368(d)(1) and §1.13681(e)(1) and (2), the adjustments to the basis of A’s stock in S described in sections 1367(a)(1) are made before the distribution rules of section 1368 are applied. Thus, A’s basis per share in the stock is $6.00 ($1 + [$50/10]) before taking into account the distribution. Under section 1367(a)(2)(A), the basis of A’s stock is decreased by distributions to A that are not includible in A’s income. Under §1.13671(c)(3), the amount of the distribution that is attributable to each share of A’s stock is $3.80 ($38 distribution/10 shares). Thus, A’s basis per share in the stock is $2.20 ($6.00 - $3.80), after taking into account the distribution. Under section 1367(a)(2)(D), the basis of each share of A’s stock in S after taking into account the distribution, $2.20, is decreased by $.60 ($6 noncapital, nondeductible expenses/10). Thus, A’s basis per share after taking into account

the nondeductible, noncapital expenses is $1.60. Under section 1367(a)(2)(B) and (C), A’s basis per share is further decreased by $2 ($20 items described in section 1367(a)(2)(B) and (C)/10 shares). However, basis may not be reduced below zero. Therefore, the basis of each share of A’s stock is reduced to zero. As of January 1, 2002, A has a basis of $0 in his shares of S stock. Pursuant to section 1366(d)(2), the $.40 of loss in excess of A’s basis in each of his shares of S stock is treated as incurred by the corporation in the succeeding taxable year with respect to A.

Example 3. Distributions by S corporations with C corporation earnings and profits for taxable years beginning before January 1, 1997. - * *

Example 4. Distributions by S corporations with earnings and profits and no net negative adjustment for taxable years beginning on or after August 18, 1998. (i) Corporation S, an S corporation, has accumulated earnings and profits of $1,000 and a balance in the AAA of $2,000 on January 1, 2001. S’s sole shareholder B holds 100 shares of stock with a basis of $20 per share as of January 1, 2001. On April 1, 2001, S makes a distribution of $1,500 to B. B’s pro rata share of the income earned by S during 2001 is $2,000 and B’s pro rata share of S’s losses is $1,500. For the taxable year ending December 31, 2001, S does not have a net negative adjustment as defined in section 1368(e)(1)(C). S does not make the election under section 1368(e)(3) and §1.1368-1(f)(2) to distribute its earnings and profits before its AAA.

(ii) The AAA is increased from $2,000 to $4,000 for the $2,000 of income earned during the 2001 taxable year. The AAA is decreased from $4,000 to $2,500 for the $1,500 of losses. The AAA is decreased from $2,500 to $1,000 for the portion of the distribution ($1,500) to B that does not exceed the AAA.

(iii) As of December 31, 2001, B’s basis in his stock is $10 ($20 + $20 ($2,000 income/100 shares)

$15 ($1,500 distribution/100 shares) - $15 ($1,500 loss/100 shares).

Example 5. Distributions by S corporations with earnings and profits and net negative adjustment for taxable years beginning on or after August 18, 1998. (i) Corporation S, an S corporation, has accumulated earnings and profits of $1,000 and a balance in the AAA of $2,000 on January 1, 2001. S’s sole shareholder B holds 100 shares of stock with a basis of $20 per share as of January 1, 2001. On April 1, 2001, S makes a distribution of $2,000 to B. B’s pro rata share of the income earned by S during 2001 is $2,000 and B’s pro rata share of S’s losses is $3,500. For the taxable year ending December 31, 2001, S has a net negative adjustment as defined in section 1368(e)(1)(C). S does not make the election under section 1368(e)(3) and §1.1368-1(f)(2) to distribute its earnings and profits before its AAA.

(ii) The AAA is increased from $2,000 to $4,000 for the $2,000 of income earned during the 2001 taxable year. Because under section 1368(e)(1)(C)(ii)and §1.1368-2(a)(ii), the net negative adjustment is not taken into account, the AAA is decreased from $4,000 to $2,000 for the portion of the losses ($2,000) that does not exceed the income earned during the 2001 taxable year. The AAA is reduced from $2,000 to zero for the portion of the distribution to B ($2,000) that does not exceed the AAA. The AAA is decreased from zero to a negative $1,500 for the portion of the $3,500 of loss that exceeds the $2,000 of income earned during the 2001 taxable year.

(iii) Under §1.1367-1(c)(1), the basis of a shareholder’s share in an S corporation stock may not be reduced below zero. Accordingly, as of December 31, 2001, B’s basis per share in his stock is zero ($20

$20 income - $20 distribution - $35 loss). Pursuant to section 1366(d)(2), the $15 of loss in excess of B’s basis in each of his shares of S stock is treated as incurred by the corporation in the succeeding taxable year with respect to B.

Par. 10. §1.1368-4 is revised to read as follows: §1.1368-4 Effective date and transition rule.

Except for §§1.1368-1(e)(2), 1.13682(a)(5), and 1.1368-3 Example 2, Exam- ple 4, and Example 5, §§1.1368-1, 1.1368-2, and 1.1368-3 apply to taxable years of the corporation beginning on or after January 1, 1994. Section 1.13681(e)(2), §1.1368-2(a)(5), and §1.1368-3 Example 2, Example 4, and Example 5 apply only to taxable years of the corporation beginning on or after August 18, 1998. For taxable years beginning before January 1, 1994, and taxable years beginning on or after January 1, 1997, and before August 18, 1998, the treatment of distributions by an S corporation to its shareholders must be determined in a reasonable manner, taking into account the statute and legislative history. Except with regard to the deemed dividend rule under §1.1368-1(f)(3), §1.1368-1(e)(2), §1.1368-2(a)(5), and §1.1368-3 Example 2, Example 4, and Example 5, return positions consistent with §§1.1368-1, 1.13682, and 1.1368-3 are reasonable for taxable years beginning before January 1, 1994. Return positions consistent with §§1.1368-1(e)(2), 1.1368-2(a)(5), and 1.1368-3 Example 2, Example 4, and Ex- ample 5 are reasonable for taxable years beginning on or after January 1, 1997, and

January 10, 2000 264 2000–2 I.R.B.

before August 18, 1998.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 11. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 12. In §602.101, paragraph (b) is

amended by adding the entry for 1.1366-1 to the table as follows: §602.101 OMB Control numbers.

(b) * * *

Robert E. Wenzel, Deputy Commissioner of

Internal Revenue.

Approved December 13, 1999.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the office of the Federal Register on December 21, 1999, 8:45 a.m., and published in the issue of the Federal Register for December 22, 1999, 64 F.R. 71641)

CFR part or section where Current OMB identified and described control No.

1.1366-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1613

with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control numbers 1545-1615, 1545-1617, and 1545-1317. Responses to these collections of information are mandatory.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

The burden of complying with the collection of information required to be reported on Form 8865 is reflected in the burden for Form 8865.

The burden of complying with the collection of information required to be reported on Form 5471 is reflected in the burden for Form 5471.

The burden of complying with the collection of information required to be reported on Form 926 is reflected in the burden for Form 926.

The estimated annual burden per respondent of complying with the collection of information in §1.6038-3(c)(1)(ii)(B) and (2)(ii)(B) varies from .5 hours to 1.5 hours, depending on individual circumstances, with an estimated average of 1 hour.

Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and to the Office of

Section 1397E.—Credit to Holders of Qualified Zone Academy Bonds

What is the 2000 qualified zone academy bond national limitation for each State, the District of Columbia, and the possessions of the United States? See Rev. Proc. 2000–10, page 287.

Section 6038.—Information Reporting With Respect to Certain Foreign Corporations and Partnerships

26 CFR 1.6038–2: Information returns required of United States persons with respect to annual accounting periods of certain foreign corporations beginning after December 31, 1962.

T.D. 8850

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Information Reporting With Respect to Certain Foreign Partnerships and Certain Foreign Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations under section 6038 of the Internal Revenue Code relating to information reporting requirements for United States persons owning interests in controlled foreign partnerships (CFPs). This document also contains amendments to the final regulations under section 6038 relating to the reporting requirements of U.S. shareholders of certain foreign corporations and amendments to the final regulations under section 6038B relating to the reporting requirements with respect to transfers of property to foreign partnerships and to foreign corporations.

DATES: Effective Dates: These regulations are effective December 29, 1999, except that §1.6038B-2(a)(5) is effective January 1, 2000.

Applicability Dates : For dates of applicability, see §§1.6038-2(l), 1.6038-3(l), and 1.6038B-2(c)(4) and (j)(3).

FOR FURTHER INFORMATION CONTACT: Eliana Dolgoff, (202) 622-3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance

2000–2 I.R.B. 265 January 10, 2000

Management and Budget, Attn: Desk Officer of the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Background

On September 9, 1998, the IRS published in the Federal Register (63 FR 48144 (REG–118966–97, 1998–39 I.R.B. 29)) proposed regulations relating to the reporting requirements under section 6038 of United States persons that are direct or indirect partners of CFPs. A public hearing on the proposed regulations was held on November 10, 1998, even though no requests to speak at the hearing were received. Though no comments were made at the hearing, written comments were received. After consideration of all of the written comments, the proposed regulations under section 6038 are adopted as revised by this Treasury decision. The revisions are discussed in the Summary of Public Comments and Explanation of Revisions section of this preamble. This document also contains amendments to certain other final regulations. These amendments are also discussed below.

Summary of Public Comments and Explanation of Revisions

A. General Comments Regarding the Proposed Section 6038 CFP Regulations

Some commentators suggested that the final regulations should exempt state and local government employee retirement plans from the section 6038 reporting requirements. The final regulations provide that trusts relating to state and local government employee retirement plans are not required to report under section 6038, unless required to do so in the instructions to Form 8865, “Return of U.S. Persons with Respect to Certain Foreign Partnerships.”

One commentator asserted that the reasonable cause exception to the section 6038 penalties appears to apply only to failures to file Form 8865 and therefore would not protect a taxpayer who files an incomplete Form 8865 because the taxpayer was unable to obtain all the re

quired information from the foreign partnership. The reasonable cause exception has been modified to make clear that it applies to both a failure to file Form 8865 and to a failure to submit all information required to be submitted.

Commentators requested that the final regulations provide that the section 6038 penalties do not apply when there is minor noncompliance with the reporting requirements under section 6038. The commentators expressed concern that taxpayers will be subject to penalties for small discrepancies in the information reported and suggested that the penalties apply only if there is a substantial failure to report the required information, or if materially false or inaccurate information is submitted. Because the IRS and Treasury believe adding such a standard might encourage taxpayers to submit incomplete Forms 8865, the standard was not added to the final regulations. A taxpayer may, nonetheless, avoid application of the section 6038 penalties because of minor noncompliance with the section 6038 reporting requirements by demonstrating reasonable cause. See §1.6038-3(k)(4).

Commentators also requested that the IRS add additional, specific reasonable cause exceptions to the section 6038 penalties. For example, one commentator requested a specific exception be provided for controlling ten-percent partners (see definition in §1.6038-3(a)(2)) that are unable to obtain all information required to be reported by controlling ten-percent partners. The final regulations do not contain additional, specific reasonable cause exceptions. Whether there is reasonable cause depends on all the facts and circumstances of the particular case. Any person who is unable to obtain information may apply for a reasonable cause determination specific to that person’s situation.

Finally, a commentator asked that in the case of an affiliated group of corporations filing a consolidated income tax return, the final regulations not require the members to file separate Forms 8865 if one member of the group files Form 8865. The final regulations adopt this recommendation. The common parent corporation of an affiliated group of corporations filing a consolidated income tax return may file one Form 8865 on behalf of all other members of the group required to file Form 8865 pursuant to sec

tion 6038 with respect to a particular foreign partnership. B. Section 6038/Section 6031 Overlap.

Some commentators requested that the final regulations address the potential overlap between section 6031 and section 6038. In general, section 6031(e) provides that a foreign partnership must file Form 1065, “U.S. Partnership Return of Income,” if it has gross income derived from sources within the United States or gross income that is effectively connected with the conduct of a trade or business within the United States. Section 6038 provides generally that a U.S. partner of a foreign partnership must file Form 8865 with respect to that partnership if the partner individually, or collectively with other ten- percent or greater U.S. partners, owns more than a fifty-percent interest in the partnership. Therefore, in some cases, both Forms 1065 and 8865 would be required to be filed with regard to the same partnership for the same tax year of the partnership. Although the two forms are not identical, and one is filed by the partnership while the other is filed by the relevant partners, the information required by the two forms is substantially the same.

Additionally, some confusion may result from the fact that the two forms contain similarly titled schedules. In particular, each form has a Schedule K-1 on which information about a partner’s distributive share of partnership income, deductions, etc., is to be reported. The IRS is working to eliminate discrepancies between the two schedules. However, even if the discrepancies are eliminated, it is still possible the two schedules will not contain identical information because one schedule will be prepared by a partner and one will be prepared by the partnership.

In response to the comments that the overlap between section 6031 and section 6038 reporting will be burdensome to taxpayers when both sets of requirements apply, and to help avoid any confusion on the part of taxpayers with respect to which Schedule K-1 they should use to compute their tax liabilities, the final section 6038 regulations reduce the burden imposed by section 6038 in the case of an overlap. They provide that if a foreign partnership completes and files Form 1065, a U.S. person required to report under section 6038 must use a copy of the filed Form 1065, including the Schedules K-1, in conjunction with fulfilling the

January 10, 2000 266 2000–2 I.R.B.

person’s section 6038 reporting obligation. Specifically, the instructions to Form 8865 will state which schedules on Form 1065 are considered equivalent to schedules on Form 8865. A U.S. partner must attach to the partner’s Form 8865 a copy of the Form 1065 schedules that are considered equivalent to the schedules the partner is required to complete on Form 8865 as a controlling fifty-percent partner (see definition in §1.6038-3(a)(1)) or as a controlling ten-percent partner. A partner should not complete a schedule on Form 8865 when the partner attaches a copy of the equivalent Form 1065 schedule to its Form 8865. Should a schedule on Form 8865 ask for information that is not required to be reported on the equivalent Form 1065 schedule, the partner is not required to report that information on its Form 8865 if a copy of the completed equivalent Form 1065 schedule is attached to its Form 8865. A partner attaching copies of schedules from Form 1065 to its Form 8865 must still complete the parts of Form 8865 that the person is required to complete as a controlling fiftypercent partner, or as a controlling tenpercent partner, and for which there is no equivalent Form 1065 schedule (for example, a partner must still complete the first page of Form 8865 and certain schedules on page two of the form).

An example of how a person will use a completed Form 1065 to fulfill its section 6038 filing obligation is as follows. Section 1.6038-3(g)(2)(iii) requires a controlling fifty-percent partner to report aggregate information about the partners’ distributive shares of income, gain, losses, deductions and credits. Such information is reported on Schedule K of Form 8865. The same information is also required to be submitted on Schedule K of Form 1065. The instructions to Form 8865 will provide that Schedules K on Forms 1065 and 8865 are equivalent. Accordingly, if the partnership completes and files a Form 1065, a controlling fiftypercent partner filing Form 8865 must attach a copy of the Schedule K from the Form 1065 to the partner’s Form 8865 and should not complete Schedule K on Form 8865. The partner must also attach all other Form 1065 schedules that are considered equivalent to Form 8865 schedules that the partner must complete as a controlling fifty-percent partner. Additionally, the partner must still complete page one of Form 8865 and Sched

ules A ”Constructive Ownership of Partnership Interest,” A-1 “Certain Partners of Foreign Partnership,” A-2 “Affiliation Schedule,” and N “Transactions Between Controlled Foreign Partnership and Partners or Other Related Entities” of Form 8865.

Similarly, a controlling ten-percent partner must submit on Schedule K-1 of Form 8865 a statement of the income, gain, losses, deductions and credits allocated to the partner’s direct interest in the partnership. See §1.6038-3(g)(1)(i). The same information is also required to be reported on Schedule K-1 of Form 1065. Therefore, if the partnership completes and files Form 1065, the partner must attach to its Form 8865 a copy of its Schedule K-1 from the Form 1065 completed by the partnership and should not complete Schedule K-1 on Form 8865. The partner is still required to complete the portions of pages one and two of Form 8865 applicable to controlling ten-percent partners, as well as Schedule N.

Another comment asserted that the proposed regulations imposed an excessive reporting burden on taxpayers and that they had the effect of nullifying the section 6031(e) limitation on reporting required of foreign partnerships. The comment suggested that the IRS require only those items specifically enumerated in section 6038(a)(1) to be reported under section 6038.

Section 6038 grants the IRS authority to require taxpayers to submit more than the items enumerated in section 6038(a)(1). Section 6038 provides that the Secretary may require the furnishing of any other information that is similar or related in nature to that specified in the first sentence of section 6038(a)(1), or which the Secretary determines to be appropriate to carry out the provision of Title 26. The IRS has determined that all of the information that the final section 6038 regulations require taxpayers to submit is necessary for the IRS to carry out the provisions of Title 26.

Additionally, as explained above, section 6031(e) and section 6038 differ with respect to whom they require to report and when the reporting obligation applies. Section 6031(e) applies only to the requirement that a Form 1065 be filed, to the application of the TEFRA partnership-level audit procedures, and to the requirement that a partnership report information about

its operations, even when there is limited U.S. ownership in the partnership. In contrast, section 6038 requires certain U.S. partners to report information when the foreign partnership in which they own an interest has substantial U.S. ownership. Section 6031(e) was added to the Internal Revenue Code at the same time that section 6038 was amended to apply to CFPs. See Taxpayer Relief Act of 1997, Public Law 105-34, sections 1141-1142 (111 Stat. 983)(1997). Therefore, rather than intending section 6031(e) to limit the amount of information required to be reported pursuant to section 6038, Congress intended the two provisions to work together to ensure that the IRS receives sufficient information about foreign partnerships. C. Tiered Partnerships

Commentators requested that section 6038 reporting apply only to first-tier CFPs, i.e., section 6038 reporting should only be required of U.S. persons with respect to foreign partnerships in which they own a direct interest. However, section 6038(e)(3)(B) provides that rules similar to the rules of section 267(c) shall apply when determining whether a person owns a fiftypercent interest in a foreign partnership. Additionally, the statute does not require that a U.S. person own its interest in the CFP directly. Therefore, the final regulations require section 6038 reporting of United States persons whose ownership interests are entirely the result of constructive ownership from other persons.

Nevertheless, certain exceptions and modifications to this rule may apply. Persons that do not own direct interests may qualify for a reduced reporting obligation pursuant to the exception for constructive owners in §1.6038-3(c)(2). Additionally, certain information required by the final section 6038 regulations must be submitted only if the partner owns a direct interest in the foreign partnership. For example, §1.6038-3(g)(1)(i) provides that the person reporting under section 6038 must provide a statement of the income, gain, losses, deductions and credits allocated to that person’s direct interest in the partnership. Accordingly, if a person is reporting under section 6038 but owns no direct interest in the partnership, that person will not have to submit information under §1.6038-3(g)(1)(i). Finally, the final regulations require attribution from nonresident alien family members only if the per

2000–2 I.R.B. 267 January 10, 2000

son to whom the interest is being attributed already owns a direct or indirect (under the rules of section 267(c)(1) or (5)) interest in the partnership. See §1.6038-3(b)(4). D. Failure to Recognize That an Arrange- ment is a Partnership or That a Partner- ship is a Foreign Partnership

Commentators expressed concern that taxpayers might fail to report under section 6038 because they failed to recognize that their arrangement constituted a partnership. Additionally, if no entity is formed under foreign law, but a partnership is determined to exist, it may be difficult to determine whether the partnership is foreign or domestic. Some commentators recommended that the IRS exclude partnerships not formed under a foreign law statute from the reporting requirements, subject to an anti-abuse rule. The final regulations do not adopt this recommendation and additional guidance on these issues is beyond the scope of this document. They do, however, provide that the section 6038 reporting requirements do not apply to any United States person with respect to a foreign partnership that has validly elected (or is deemed to have elected) to be excluded from the application of subchapter K. See §1.6038-3(e). Additionally, a taxpayer that does not comply with section 6038 because it mistakenly concluded that its arrangement was not a partnership, or that it was not a foreign partnership, may apply for a reasonable cause determination. See §1.6038-3(k)(4). E. Section 6038 (CFPs) Effective Date .

Section 1.6038-3 is applicable to CFP tax years ending on or after December 31, 2000. United States persons are not required to report under section 6038 for CFP tax years ending before December 31, 2000. F. Availability of Form 8865 .

A United States person required to report information pursuant to section 6038 must do so by completing and filing Form 8865. A final version of Form 8865 will be released prior to January 1, 2000. Taxpayers will be able to download a copy of the form and its instructions from the IRS Internet website located at www.irs.ustreas.gov. G. Clarification of Section 6501(c)(8).

Section 6501(c)(8) provides that in the case of information required to be re

ported under section 6038, 6038A, 6038B, 6046, 6046A, or 6048, the time for assessment of any tax imposed by Title 26 with respect to any event or period to which such information relates shall not expire before the date that is three years after the date on which the Secretary is furnished the information required to be reported under such section. Taxpayers have expressed uncertainty about the application of this rule in the context of a failure to properly report information required under sections 6038, 6038B, or 6046A, with respect to an interest in a foreign corporation or a foreign partnership, as applicable. The IRS and Treasury wish to clarify that if a U.S. person fails to comply with sections 6038, 6038B, or 6046A, the extended statute of limitations provided by section 6501(c)(8) shall apply only to the tax consequences related to the information required to be reported under the relevant reporting section and not to all transactions within the U.S. person’s tax year at issue. For example, if a U.S. person with a calendar tax year fails to comply with section 6038 for a controlled foreign partnership’s 2001 calendar tax year, section 6501(c)(8) will only extend the statute of limitations applicable to the U.S. person’s 2001 tax year with respect to any tax consequences associated with the U.S. person’s interest in the foreign partnership during the partnership’s 2001 tax year. H. Amendment to Final Section 6038 Foreign Corporation Regulations

In order to reduce the burden that section 6038 imposes on taxpayers, this document also amends the final regulations under section 6038 applicable to shareholders of certain foreign corporations. The regulations provide that if a United States person does not own a direct or indirect interest in the foreign corporation, but is attributed an interest from a nonresident alien, the person is not required to report under section 6038. This amendment is effective for tax years of foreign corporations ending on or after December 29, 1999. I. Amendments to Final Section 6038B Regulations Applicable to Transfers of Property to Foreign Partnerships

On February 5, 1999, the IRS published in the Federal Register final regulations under section 6038B relating to the information reporting requirements

for certain contributions of property by United States persons to foreign partnerships. See T.D. 8817, 1999–8 I.R.B. 51 (64 FR 5713). This document makes several amendments to those final regulations. Each amendment either reduces the burden that section 6038B imposes on taxpayers, or does not affect the burden imposed by section 6038B.

First, the amount of information required to be submitted by a person reporting a transfer of property to a foreign partnership is reduced. Rather than submit the names and addresses of all the foreign partnership’s partners, the person reporting the transfer (the transferor) must provide only the names and addresses of the United States partners that owned a tenpercent or greater direct interest in the foreign partnership during the transferor’s tax year in which the reportable transfer occurred, and the names and addresses of any other United States or foreign persons that were direct partners in the partnership during that tax year and that were related to the transferor under section 6038B during that tax year. A person who transferred solely cash and who did not own a ten-percent or greater interest after the transfer is still not required to report the names and addresses of any of the foreign partnership’s other partners. This amendment applies to tax years of U.S. persons required to report under section 6038B beginning on or after January 1, 2000.

Second, this document changes the time for filing Form 8865 to report a transfer to a foreign partnership in certain instances. Currently, §1.6038B-2(a)(5)(ii) provides that if a United States person required to report a transfer to a foreign partnership is also required to report pursuant to section 6038 for the period in which the transfer occurred, then the United States person must report the transfer on the Form 8865 completed for the partnership’s tax year in which the transfer occurred. This document deletes the section 6038B/section 6038 overlap rule, so that a United States person must always report with its tax return for a particular tax year all of its section 6038B transfers that took place during that year, regardless of whether any of the transfers occurred during a period for which section 6038 reporting is also required. This amendment applies to tax years of U.S. persons required to report under section 6038B beginning on or after January 1, 2000.

January 10, 2000 268 2000–2 I.R.B.

The following example illustrates this amendment. Assume the tax year of FPS, a foreign partnership, ends on Sept 30. US, a United States person and calendar year taxpayer, owns a sixty- percent interest in FPS and therefore is a controlling fifty- percent partner of FPS . Accordingly, US must report under section 6038 with respect to FPS . On October 15, 2001, US transfers property to FPS in a section 721 transaction. US is required to report this transfer under section 6038B because US owns at least a ten-percent interest in the partnership immediately after the transfer. See §1.6038B-2(a)(1)(i). Under the existing section 6038B regulations, US is required to report the October 15, 2001 property transfer on the Form 8865 for FPS ’s tax year ending September 30, 2002, that will be filed with US ’s 2002 income tax return.

Under the amendments to section 6038B contained in this document, US must attach to its 2001 income tax return a Form 8865 on which is reported the October 15, 2001 property transfer and information about FPS for FPS ’s tax year ending September 30, 2001. Assuming US is also a controlling fiftypercent partner during FPS ’s tax year ending September 30, 2002, when US files its 2002 income tax return, US must attach to that return Form 8865 on which is reported information about FPS for FPS ’s tax year ending September 30, 2002. US should not report the October 15, 2001, property transfer on the Form 8865 filed with US ’s 2002 income tax return.

The third and final amendment to the section 6038B regulations provides an additional opportunity for United States persons to timely report certain transfers to foreign partnerships. Even if not reported in accordance with the rules provided in §1.6038B-2(a)(5) or (j)(1) or (2), a transfer to a foreign partnership that occurred before January 1, 2000, will nevertheless be considered timely reported if the transferor reports it on a Form 8865 attached to an amended tax return for the transferor’s tax year in which the transfer occurred, provided such amended return is filed no later than September 15, 2000.

Additionally, since issuing the section 6038B regulations in February 1999,

certain tax-exempt organizations have contacted the IRS and Treasury to request that they be specifically excluded from the obligation under section 6038B to report their property transfers to foreign partnerships. The IRS and Treasury invite comments regarding the extent to which section 6038B reporting should be required of tax-exempt organizations. J. Amendment to Final Section 6038B Regulations Applicable to Transfers of Property to Foreign Corporations

This document makes one amendment to the final section 6038B regulations governing the reporting requirements with respect to transfers to foreign corporations. The amendment reduces the burden that section 6038B imposes on taxpayers.

Pursuant to §1.367(a)-3(c)(8), section 367(a) does not apply to a domestic corporation’s transfer of its own stock or securities in connection with the performance of services, if the transfer is considered to be to a foreign corporation solely by reason of §1.83-6(d)(1). Section 1.83-6(d)(1) provides that if a shareholder of a corporation transfers property to an employee of such corporation in consideration of services performed for the corporation, the transaction is considered to be a contribution of such property to the capital of such corporation by the shareholder, and immediately thereafter a transfer of such property by the latter corporation to the employee.

The final regulations under section 6038B do not contain an exception to the reporting requirements that corresponds to the rule in §1.367(a)-3(c)(8). Therefore, a transfer by a domestic corporation of its stock or securities to an employee of the domestic corporation’s foreign subsidiary may be excluded from the application of section 367(a), yet still reportable under section 6038B. This document provides that such a transfer is not required to be reported under section 6038B if the transfer is considered to be to a foreign corporation solely by reason of §1.83-6(d)(1) and the fair market value of the property transferred did not exceed $100,000. This amendment is effective as if it had been included in TD 8770 (63 FR 33550), and therefore applies to transfers occurring on or after July 20, 1998.

Special Analyses

It has been determined that these final regulations are not a significant regulatory action as defined in Executive Order 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) does not apply to these final regulations. It is hereby certified that the collections of information contained in these final regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that the number of small entities that will be required to file the form is not substantial. Accordingly, 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, these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Eliana Dolgoff, Office of the Associate Chief Counsel (International). However, other personnel from the IRS and the Treasury Department participated in their development.

Amendments to the Regulations

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

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Section 1.6038-2 also issued under 26 U.S.C. 6038. Section 1.6038-3 also issued under 26 U.S.C. 6038. * * *

Par. 2. In §1.367(a)-3, paragraph (c)(8) is amended by adding a sentence to the end of the paragraph to read as follows: §1.367(a)-3 Treatment of transfers of stock or securities to foreign corpora- tions.

2000–2 I.R.B. 269 January 10, 2000

(c) * * * (8) * * * The transfer may still, however, be reportable under section 6038B. See §1.6038B-1(b)(2)(i)(A)( 4 ) and (b)(2)(i)(B)( 4 ).

Par. 3. Section 1.6038-2 is amended as follows:

A sentence is added to the end of paragraph (j)(2)(i)(C).
Paragraph (l) is added. The revised and added provisions read as follows: §1.6038-2 Information returns required of United States persons with respect to an- nual accounting periods of certain for- eign corporations beginning after Decem- ber 31, 1962.

(j) * * * (2) * * * (i) * * * (C) * * * (For a rule regarding attribution from a nonresident alien, see paragraph (l) of this section).

(l) Other persons excepted from filing . For tax years of foreign corporations ending on or after December 29, 1999, any person required to furnish information under this section with respect to a foreign corporation does not have to furnish that information if the following conditions are met—

(1) Such person does not own a direct or indirect interest in the foreign corporation; and

(2) Such person is required to furnish information solely by reason of attribution of stock ownership from a nonresident alien(s) under paragraph (c) of this section.

Par. 4. Section 1.6038-3 is added to read as follows: §1.6038-3 Information returns required of certain United States persons with respect to controlled foreign partnerships (CFPs).

(a) Persons required to make return (1) Controlling fifty- percent partners . The term controlling fifty-percent partner means a United States person that controlled (as defined in paragraph (b)(1) of this section) the foreign partnership at any time during the partnership’s tax year (as defined in paragraph (b)(8) of this section). Except as provided in paragraph (c), (d), or (e) of this section, for each tax

year of a foreign partnership during which the partnership has one or more controlling fifty-percent partners, each controlling fifty-percent partner must complete and file Form 8865, “Return of U.S. Persons With Respect To Certain Foreign Partnerships,” containing the information described in paragraph (g) of this section.

(3) Separate returns for each partner- ship. A United States person required to report under this paragraph (a) must file a separate Form 8865 for each foreign partnership with respect to which the person is a controlling fifty-percent partner or a controlling ten-percent partner.

(b) Ownership determinations and def- initions —(1) Control . Control of a foreign partnership is ownership of more than a fifty-percent interest in the partnership.

(2) Fifty-percent interest . A fifty-percent interest in a partnership is an interest equal to fifty percent of the capital interest in such partnership, an interest equal to fifty percent of the profits interest in such partnership, or an interest to which fifty percent of the deductions or losses of such partnership are allocated.

(3) Ten-percent interest . A ten-percent interest in a partnership is an interest equal to ten percent of the capital interest in such partnership, an interest equal to

(2) Controlling ten-percent partners . If at any point during a foreign partnership’s tax year (as defined in paragraph (b)(8) of this section) a United States person owned a ten- percent or greater interest in the partnership while the partnership was controlled by United States persons owning ten- percent or greater interests, such United States person is a controlling tenpercent partner. See paragraph (b)(1) of this section for the definition of control. However, a United States person is not a controlling ten-percent partner with respect to a particular foreign partnership for a particular tax year of the foreign partnership if at any point during that year the partnership had a controlling fifty-percent partner, as defined in paragraph (a)(1) of this section. Except as provided in paragraph (c), (d), or (e) of this section, for each tax year of a partnership during which the partnership has controlling tenpercent partners, each controlling ten-percent partner must complete and file Form 8865 containing the information described in paragraph (g)(1) of this section.

ten percent of the profits interest in such partnership, or an interest to which ten percent of the deductions or losses of such partnership are allocated.

(4) Constructive ownership rules . For purposes of determining an interest in a partnership, the constructive ownership rules of section 267(c) (other than section 267(c)(3)) apply, taking into account that such rules refer to corporations and not to partnerships. However, an interest will be attributed from a nonresident alien under the family attribution rules of section 267(c)(2) and (4) only if the person to whom the interest is attributed owns a direct or indirect (under the rules of 267(c)(1) or (5)) interest in the foreign partnership.

(5) Determination of amount of interest . Whether a person owns a fifty-percent interest, or a ten-percent interest, as described in paragraphs (b)(2) and (3) of this section, is determined for each tax year of the foreign partnership by reference to the agreement of the partners relating to such interests during that tax year.

(6) Definition of United States person . The term United States person is defined in section 7701(a)(30).

(7) Definition of a foreign partnership . A foreign partnership is a partnership described in section 7701(a)(5).

(8) Tax year of a foreign partnership . The tax year of a foreign partnership is determined under section 706.

(9) Examples . The rules of paragraph (a) of this section and this paragraph (b) are illustrated by the following examples:

Example 1. Sole U.S. partner does not own more than a fifty-percent interest. No United States person owns any interest (directly or constructively) in FPS, a foreign partnership whose tax year under section 706 is the calendar year. On January 1, 2001, US, a United States person with the calendar year as its tax year, contributes property to FPS in exchange for a 40% interest in a section 721 transaction. No United States persons acquire directly or constructively any other interests in FPS during FPS ’s 2001 tax year. US is not a controlling fifty-percent partner during FPS ’s 2001 tax year. US did not own during that tax year, either directly or constructively, more than a 50% interest in the partnership under paragraphs (b)(2) and (4) of this section. Also, US is not a controlling ten-percent partner; although US owned a 10% or greater interest, US persons owning at least 10% interests did not control FPS . Therefore, US does not have to file with its 2001 income tax return a Form 8865 with respect to FPS under

January 10, 2000 270 2000–2 I.R.B.

section 6038. (But see section 6038B for the reporting obligations of US with respect to its transfer of property to FPS and section 6046A for the reporting obligation of US with respect to its acquisition of an interest in FPS . See also §1.6046A- 1(e)(1) regarding the overlap between sections 6038B and 6046A). Example 2. Controlling ten-percent partners. Assume the same facts as in Example 1 . In addition, on January 1, 2002, US1, a United States person unrelated to US and a calendar year taxpayer, purchases a 15% interest in FPS from a foreign partner of FPS . Neither US nor US1 is a controlling fiftypercent partner during FPS ’s 2002 tax year because neither one owns more than a 50% percent interest in FPS during that year. However, US and US1 are controlling ten-percent partners for that year because each owns at least a 10% interest ( US owns a 40% interest and US1 owns a 15% interest) and together they control FPS because collectively they own more than a 50% interest in FPS . As controlling ten-percent partners, under section 6038, each is required to file a Form 8865 with its 2002 income tax return. ( US1 must also report its acquisition of the 15% interest in FPS under section 6046A on its Form 8865 filed with its 2002 income tax return.)

Example 3. Constructive ownership rules . Assume the same facts as in Example 2 . In addition, on January 1, 2003, US2, a United States person and the brother of US, purchases 50% of the stock of FC, a foreign corporation. FC owns a 20% interest in FPS . Thus, under sections 6038(e)(3) and 267(c)(1), US2 indirectly owns a 10% interest in FPS (10% is US2 ’s proportionate share of FC ’s 20% interest in FPS ), and under sections 6038(e)(3) and 267(c)(2), US2 is attributed US ’s 40% interest. Additionally, US directly owns a 40% interest in FPS and is attributed US2 ’s 10% interest pursuant to section 6038(e)(3) and section 267(c)(2). Therefore, US2 is considered to own a 50% interest (10% indirectly and 40% from US ) in FPS, and US is considered to own a 50% interest in FPS (40% directly and 10% from US2 ). FPS has no controlling fifty-percent partners, because neither US, US1, nor US2, owns a greater than 50% interest. However, US, US1, and US2 are each controlling ten- percent partners and each must file Form 8865 pursuant to section 6038 for FPS ’s 2003 tax year ending December 31, 2003. Each must attach Form 8865 to its tax return for its 2003 tax year.

Example 4. Controlling fifty-percent partners . Assume the same facts as in Example 3 . In addition, on June 1, 2004, US acquires an additional 1% direct interest in FPS . US is now a controlling fifty-percent partner of FPS, because US owns a 41% interest directly and a 10% interest constructively from US2 . US2 is also a controlling fifty-percent partner, because US2 owns 10% indirectly and 41% con

structively from US . Both US and US2 are required to file Form 8865 containing all the information required to be submitted by controlling fifty-percent partners. (But see paragraph (c)(1) of this section, which contains filing exceptions when there are multiple controlling fifty-percent partners). US1 is no longer a controlling ten-percent partner because FPS now has at least one controlling fifty-percent partner, and US1 does not qualify as a controlling fifty-percent partner. Therefore, US1 is not required to file Form 8865 under section 6038.

Example 5. Constructive ownership from a non- resident alien . US, a United States person, does not own directly or constructively an interest in FPS, a foreign partnership. The tax year of FPS is the calendar year. NRA, a nonresident alien, is the mother of US . In 2002, NRA acquires a 55% interest in FPS . Because US owns neither a direct nor a constructive interest in FPS under sections 6038(e)(3) and 267(c)(1) or (5), NRA ’s interest is not attributed to US under sections 6038(e)(3) and 267(c)(2). If in 2003 NRA becomes a United States person, NRA ’s interest will be attributed to US . However, US is excused from filing Form 8865 if US satisfies the requirements of the constructive owners exception in paragraph (c)(2) of this section. In 2003, NRA is a controlling fifty-percent partner and must file a Form 8865 under section 6038 for FPS ’s 2003 tax year. (c) Exceptions when more than one United States person is required to file Form 8865 pursuant to section 6038 —(1) Multiple controlling fifty-percent partners —(i) In general . If, with respect to the same foreign partnership for the same tax year, more than one United States person is a controlling fifty- percent partner, then in lieu of each controlling fifty-percent partner filing a separate Form 8865, only one Form 8865 from one of the controlling fifty-percent partners is required, provided all of the requirements of paragraph (c)(1)(ii) of this section are satisfied. A person that is a controlling fifty-percent partner solely because of an interest to which deductions or losses are allocated may file the single return only if there is no United States person that is a controlling fifty-percent partner by reason of an interest in capital or profits.

(ii) Requirements —(A) The person undertaking the filing obligation must file Form 8865 with that person’s income tax return in the manner provided by Form 8865 and the accompanying instructions. The return must contain all of the information that would have been required to be reported by this section if each controlling fifty-percent partner had filed its own

Form 8865.

(B) Any controlling fifty-percent partner not filing Form 8865 must file with its income tax return a statement titled “Controlled Foreign Partnership Reporting” containing the following information—

( 1 ) A statement that the person qualified as a controlling fifty-percent partner, but is not submitting Form 8865 pursuant to the multiple controlling fifty-percent partners exception;

( 2 ) The name, address, and taxpayer identification number (if any) of the foreign partnership of which the person qualified as a controlling fifty-percent partner;

( 3 ) A representation that the filing requirement has been or will be satisfied;

( 4 ) The name and address of the person filing the single return;

( 5 ) The Internal Revenue Service Center where the single return is required to be filed; and

( 6 ) Any additional information that Form 8865 and the accompanying instructions require.

(iii) Penalties . If the requirements listed in paragraph (c)(1)(ii) of this section are not satisfied, a United States person that did not file a Form 8865 pursuant to this paragraph will be subject to the penalties in paragraph (k) of this section, unless the reasonable cause provision in paragraph (k)(4) of this section is satisfied.

(2) Certain constructive owners ex- cepted from furnishing information —(i) In general . A United States person that does not own a direct interest in the foreign partnership and that is required to file Form 8865 under this section solely by reason of constructive ownership from a United States person(s) pursuant to paragraph (b)(4) of this section (an indirect partner) is not required to file Form 8865 if all of the requirements listed in paragraph (c)(2)(ii) of this section are met.

(ii) Requirements —(A) The United States person(s) whose interest the indirect partner constructively owns reports all the information such person(s) is required to submit under this section, unless such person also is required to file solely by reason of constructive ownership from a United States person(s) pursuant to paragraph (b)(4) of this section, or another person reports the information pursuant to paragraph (c)(1) of this section.

(B) The indirect partner files with its income tax return a statement titled “Con

2000–2 I.R.B. 271 January 10, 2000

person reporting under section 6038;

(iv) A statement of income, gain,

trolled Foreign Partnership Reporting” containing the following information—

( 1 ) A representation that the indirect partner was required to file Form 8865, but is not doing so pursuant to the constructive owners exception;

( 2 ) The names and addresses of the United States persons whose interests the indirect partner constructively owns;

( 3 ) The name and address of the foreign partnership with respect to which the indirect partner would have had to have filed Form 8865 but for this exception; and

( 4 ) Any additional information that Form 8865 and the accompanying instructions require.

(iii) Penalties . A United States person that pursuant to this paragraph (c)(2) does not file a return will be subject to the penalties in paragraph (k) of this section if the requirements listed in paragraph (c)(2)(ii) of this section are not satisfied, unless such failure is due to reasonable cause, as defined in paragraph (k)(4) of this section.

(iv) Overlap with multiple controlling fifty-percent partners exception —(A) If a United States person qualifies for both the exception in paragraph (c)(1) of this section and the exception in this paragraph (c)(2), such person may only utilize the multiple controlling fifty-percent partners exception in paragraph (c)(1) of this section to avoid filing Form 8865.

(B) Example . The following example illustrates the operation of this paragraph (c)(2)(iv):

Example . US is a U.S. citizen. US owns 100% of the stock of DC, a domestic corporation. DC owns a 60% direct interest in FPS, a foreign partnership. DC and US are the only U.S. persons that own interests directly or constructively in FPS . DC owns directly a greater than 50% interest in FPS . US constructively owns DC ’s interest pursuant to sections 6038(e)(3) and 267(c)(1). Therefore, both DC and US are controlling fifty-percent partners. US qualifies for both the exception in paragraph (c)(1) of this section (multiple controlling fifty-percent partners) and the exception in paragraph (c)(2) of this section (constructive owner exception). US may only utilize the paragraph (c)(1) exception to avoid its filing obligation. Accordingly, DC may file a single Form 8865 on behalf of US and itself. However, that form must contain all the information that would have been submitted had DC and US each submitted a separate Form 8865.

(3) Members of an affiliated group of corporations filing a consolidated return.

If one or more members of an affiliated group of corporations filing a consolidated return are required under section 6038 to file a Form 8865 for a particular foreign partnership, the common parent corporation may file one Form 8865 on behalf of all of the members of the group required to report under section 6038. Except with respect to group members who also qualify under the exception in paragraph (c)(2) of this section, the Form 8865 must contain all the information that would have been required to be submitted if each group member were required to file its own Form 8865.

(d) Exception for certain trusts . Trusts relating to state and local government employee retirement plans are not required to report under this section, unless the instructions to Form 8865 provide otherwise.

(e) Reporting under this section not re- quired with respect to partnerships ex- cluded from the application of subchapter K . The reporting requirements of this section will not apply to any United States person in respect of an eligible partnership as described in §1.761-2(a) if such partnership has validly elected to be excluded from all of the provisions of subchapter K of chapter 1 of the Internal Revenue Code in the manner specified in §1.761-2(b)(2)(i), or such partnership is deemed to have elected to be excluded from all of the provisions of subchapter K of chapter 1 of the Internal Revenue Code in accordance with the provisions of §1.761-2(b)(2)(ii).

(f) Period covered by return . The information required under this section must be furnished for the tax year of the foreign partnership ending with or within the United States person’s tax year. See section 706 for rules regarding tax years of partnerships.

(g) Contents of return —(1) Informa- tion required to be submitted by control- ling fifty-percent partners and controlling ten-percent partners . All controlling fifty-percent partners and all controlling ten-percent partners must submit the following information on Form 8865 in the form and manner and to the extent prescribed by Form 8865 and its instructions—

(i) A statement of the income, gain, losses, deductions and credits allocated to the direct interest in the partnership of the

(ii) A list of all partnerships (foreign or domestic) in which the foreign partnership owned a direct interest, or owned a constructive interest of ten percent of more under the rules of section 267(c)(1) or (5), during the partnership’s tax year for which the Form 8865 is being filed;

(iii) Information about all foreign entities that were disregarded as entities separate from their owner under §§301.7701-2 and 301.7701-3 that were owned by the foreign partnership during the partnership’s tax year for which the Form 8865 is being filed;

(iv) A summary of the transactions that took place during the partnership’s tax year between the partnership and the person filing the return, between the partnership and any other partnership of which the person filing the return is a controlling fifty-percent partner, and between the partnership and any corporation controlled (under section 6038(e)(2) and the regulations thereunder) by the person filing the return; and

(v) Any other information that Form 8865 or its accompanying instructions require to be submitted.

(2) Additional information required to be submitted by controlling fifty-percent partners . In addition to the information required pursuant to paragraph (g)(1) of this section, controlling fifty-percent partners must also submit the following information in the form and manner and to the extent required by Form 8865 and its instructions—

(i) A list of the names, addresses and tax identification numbers (if any) of each United States person that owned a direct interest of ten percent or more in the partnership during the partnership’s tax year, and of each United States and foreign person whose interests in the partnership the controlling fifty-percent partner constructively owned under paragraph (b)(4) of this section during the partnership’s tax year;

(ii) A list of transactions between the partnership and any United States person owning at the time of the transaction at least a 10-percent direct interest (as defined in paragraph (b)(3) of this section) in the foreign partnership;

(iii) A statement of the aggregate of the partners’ distributive shares of items of income, gain, losses, deductions and credits;

January 10, 2000 272 2000–2 I.R.B.

losses, deductions and credits allocated to each United States person holding a direct interest in the foreign partnership of ten percent or more; and

(v) Any other informa tion Form 8865 or its accompanying instructions require controlling fifty-percent partners to submit.

(h) Method of reporting . Except as otherwise provided on Form 8865 or the accompanying instructions, all amounts required to be furnished on Form 8865 must be expressed in United States dollars. All statements required on or with Form 8865 pursuant to this section must be in English.

(i) Time and place for filing return (1) In general . Form 8865 must be filed with the United States person’s income tax return on or before the due date (including extensions) of that return. If the United States person is not required to file an income tax return for its tax year with which or within which the foreign partnership’s tax year ends, but is required to file an information return for that year (for example, Form 1065, “U.S. Partnership Return of Income,” or Form 990, “Return of Organization Exempt from Income Tax”), the Form 8865 must be filed with the United States person’s information return filed on or before the due date (including extensions) of that return.

(2) Duplicate return . If required by the instructions to Form 8865, a duplicate Form 8865 (including attachments and schedules) must also be filed.

(j) Overlap with section 6031 —(1) In general . A partner may be required to file Form 8865 under this section and the foreign partnership in which it is a partner may also be required to file a Form 1065 under section 6031(e) for the same partnership tax year. However, if a foreign partnership completes and files Form 1065, the United States partner must use a copy of the relevant parts of Form 1065 to fulfill certain of its filing obligations under section 6038. Specifically, instead of completing the Form 8865 schedules that the person would otherwise be required to complete as a controlling fiftypercent or a controlling ten-percent partner, the person must instead attach to its Form 8865 copies of the relevant schedules from Form 1065 that the instructions to Form 8865 state are considered equivalent to schedules on Form 8865. Should a

schedule on Form 8865 ask for information that is not required to be reported on the equivalent Form 1065 schedule, the partner is not required to report that information on its Form 8865 if a copy of the completed equivalent Form 1065 schedule is attached to its Form 8865. A person attaching copies of schedules from Form 1065 to its Form 8865 must still complete the parts of Form 8865 that the person is required to complete as a controlling fifty-percent partner, or a controlling tenpercent partner, and for which there is no equivalent Form 1065 schedule (for example, the first page of Form 8865).

(2) Example . The following example illustrates the application of this paragraph (j):

Example . US, a United States citizen, owns a 55% interest in FPS, a foreign partnership and calendar year taxpayer. Because US owns more than a 50% interest in FPS, US is a controlling fifty-percent partner of FPS and must file a Form 8865 with respect to FPS . During 2001, FPS earns gross income that is effectively connected with the conduct of a trade or business within the United States. Therefore, pursuant to section 6031(e)(2)(B), FPS must file Form 1065 for its 2001 tax year. If FPS completes and files Form 1065, US must use copies of the relevant schedules from Form 1065 to complete US ’s Form 8865 for FPS ’s 2001 tax year. If FPS instead had a September 30 tax year pursuant to section 706, then US must attach to its Form 1040 for US ’s 2001 tax year a Form 8865 completed with respect to FPS ’s tax year ending September 30, 2001. If FPS filed a Form 1065 for its tax year ending September 30, 2001, then US must use that Form 1065 to fulfill in part its reporting obligations under section 6038 by attaching the relevant schedules from the Form 1065 to US ’s Form 8865.

(k) Failure to comply with reporting re- quirement —(1) In general . Any United States person required to file Form 8865 under Section 6038 and this section that fails to comply (as defined in paragraph (k)(2) of this section) with the reporting requirements of this section, will be subject to the penalties described in paragraph (k)(3) of this section.

(2) Failure to comply . A failure to comply is separately determined for each foreign partnership for which a United States person has a section 6038 reporting obligation. A failure to comply with the requirements of section 6038 includes the following—

(i) The failure to report at the proper time and in the proper manner any information required to be reported under the

rules of this section; or

(ii) The provision of false or inaccurate information in purported compliance with the requirements of this section.

(3) Penalties . A United States person that fails to comply (as defined in paragraph (k)(2) of this section) with the reporting requirements of this section must pay the following penalties, subject to the reasonable cause exception in paragraph (k)(4) of this section:

(i) Dollar amount penalty —(A) $10,000 penalty. A penalty of $10,000 shall be imposed for each tax year of each foreign partnership with respect to which a failure to comply occurs.

(B) Increase in penalty . If a failure to comply with the applicable reporting requirements of section 6038 and this section continues for more than 90 days after the date on which the Commissioner or the Commissioner’s delegate mails notice of the failure to the United States person required to file Form 8865, the person must pay an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure continues after the 90-day period has expired.

(C) Limitation . The additional penalty imposed on any United States person by section 6038(b)(2) and paragraph (k)(3)(i)(B) of this section is limited to a maximum of $50,000 for each partnership for each tax year with respect to which the failure occurs.

(ii) Penalty of reducing foreign tax credit —(A) Effect on foreign tax credit . Failure to comply with the reporting requirements of section 6038 and this section may cause a reduction of foreign tax credits under section 901 (taxes of foreign countries and of possessions of the United States). In applying section 901 to a United States person for any tax year with or within which its foreign partnership’s tax year ended, the amount of taxes paid (and deemed paid under sections 902 and 960) by the United States person will be reduced by 10 percent if the person fails to comply. However, no tax deemed paid under section 904(c) will be reduced under the provisions of this paragraph (k)(3)(ii).

(B) Reduction for continued failure . If a failure to comply with the reporting requirements of section 6038 and this section continues for more than 90 days after the date on which the Commissioner or

2000–2 I.R.B. 273 January 10, 2000

the Commissioner’s delegate mails notice of the failure to the person required to file Form 8865, then the amount of the reduction in paragraph (k)(3)(ii)(A) of this section will be 10 percent, plus an additional 5 percent for each 3-month period (or fraction thereof) during which the failure continues after the 90-day period has expired.

(C) Limitation on reduction . The amount of the reduction under paragraphs (k)(3)(ii)(A) and (B) of this section for each failure to furnish information required under this section will not exceed the greater of $10,000, or the gross income of the foreign partnership for its tax year with respect to which the failure occurred.

(D) Offset for dollar amount penalty imposed . The total amount of the reduction which, but for this paragraph (k)(3)(ii)(D), may be made under this paragraph (k)(3)(ii) with respect to any separate failure, may not exceed the maximum amount of the reductions that may be imposed, reduced (but not below zero) by the dollar amount penalty imposed by paragraph (k)(3)(i) of this section with respect to the failure.

(4) Reasonable cause limitation . The time prescribed for filing a complete Form 8865, and the beginning of the 90day period after the Commissioner or the Commissioner’s delegate mails notice under paragraphs (k)(3)(i)(B) and (ii)(B) of this section, will be treated as being not earlier than the last day on which reasonable cause existed for failure to furnish the information. The United States person may show reasonable cause by providing a written statement to the Commissioner’s delegate having jurisdiction over the person’s return to which the Form 8865 should have been attached, setting forth the reasons for the failure to comply. Whether a failure to comply was due to reasonable cause will be determined by the Commissioner, or the Commissioner’s delegate, under all the facts and circumstances.

(5) Statute of limitations. For exceptions to the limitations on assessment in the event of a failure to provide information under section 6038, see section 6501(c)(8). (l) Effective date . This section applies to tax years of a foreign partnership ending on or after December 31, 2000.

Par. 5. Section 1.6038B-1 is amended as follows:

The heading is revised.
The first three sentences of paragraph (b)(1)(i) are removed and four sentences are added in their place.
Paragraph (b)(2)(i)(A)(4) is added.
Paragraph (b)(2)(i)(B)(3) is revised.
Paragraph (b)(2)(i)(B)(4) is added.
Paragraph (g) is revised. The added and revised provisions read as follows: §1.6038B-1 Reporting of certain trans- fers to foreign corporations .

(b) * * * (1) * * * (i) Reporting proce- dure . Except for stock or securities qualifying under the special reporting rule of paragraph (b)(2) of this section, and certain exchanges described in section 354 (listed below), any U.S. person that makes a transfer described in section 6038B(a)(1)(A), 367(d) or (e), is required to report pursuant to section 6038B and the rules of this section and must attach the required information to Form 926, “Return by Transferor of Property to a Foreign Corporation.” For special rules regarding cash transfers made in tax years beginning after February 5, 1999, see paragraphs (b)(3) and (g) of this section. For purposes of determining a U.S. transferor that is subject to section 6038B, the rules of §1.367(a)-1T(c) and §1.367(a)3(d) shall apply with respect to a transfer described in section 367(a), and the rules of §1.367(a)-1T(c) shall apply with respect to a transfer described in section 367(d). Additionally, if in an exchange described in section 354, a U.S. person exchanges stock of a foreign corporation in a reorganization described in section 368(a)(1)(E), or a U.S. person exchanges stock of a domestic or foreign corporation for stock of a foreign corporation pursuant to an asset reorganization described in section 368(a)(1)(C),(D), or (F), that is not treated as an indirect stock transfer under section 367(a), then the U.S. person exchanging stock is not required to report under section 6038B. * * *

(2) * * * (i) * * * (A) * * * ( 4 ) The transfer is considered to be to a foreign corporation solely by reason of

§1.83-6(d)(1) and the fair market

value of the property transferred did not exceed $100,000; or

(B) * * * ( 3 ) The transferor properly reported the income from the transfer on its timelyfiled (including extensions) Federal income tax return for the taxable year that includes the date of the transfer; or

( 4 ) The transfer is considered to be to a foreign corporation solely by reason of §1.83-6(d)(1) and the fair market value of the property transferred did not exceed $100,000.

(g) This section applies to transfers occurring on or after July 20, 1998, except for transfers of cash made in tax years beginning on or before February 5, 1999, which are not required to be reported under section 6038B, and except for paragraph (e) of this section, which applies to transfers that are subject to §§1.367(e)1(f) and 1.367(e)-2(e). See §1.6038B-1T for transfers occurring prior to July 20, 1998. See also §1.6038B-1T(e) in effect prior to August 9, 1999, (as contained in 26 CFR part 1 revised April 1, 1999) for transfers described in section 367(e) that are not subject to §§1.367(e)-1(f) and 1.367(e)-2(e). Par. 6. Section 1.6038B-2 is amended as follows:

Paragraph (a)(5) is revised.
Paragraph (c)(4) is revised.
Paragraph (c)(6) is amended by removing the period at the end and adding “; and” in its place.
Paragraph (j)(1) introductory text is amended by revising the first sentence.
Paragraph (j)(3) is added. The revised and added provisions read as follows: §1.6038B-2 Reporting of certain transfers to foreign partnerships.

(a) * * * (5) Time for filing Form 8865 . The Form 8865 on which a transfer is reported must be attached to the transferor’s timely filed (including extensions) income tax return for the tax year that includes the date of the transfer. If the person required to report under this section is not required to file an income tax return for its tax year during which the transfer occurred, but is required to file an information return for that year (for example, Form 1065, “U.S. Partnership Return of Income,” or Form

January 10, 2000 274 2000–2 I.R.B.

990, “Return of Organization Exempt from Income Tax”), the person should attach the Form 8865 to its information return.

(c) * * * (4) The names and addresses of the other partners in the foreign partnership, unless the transfer is solely of cash and the transferor holds less than a ten-percent interest in the transferee foreign partnership immediately after the transfer. However, for tax years of U.S. persons beginning on or after January 1, 2000, the person reporting pursuant to section 6038B (the transferor) must provide the names and addresses of each United States person that owned a ten-percent or greater direct interest in the foreign partnership during the transferor’s tax year in which the transfer occurred, and the names and addresses of any other United States or foreign persons that were direct partners in the foreign partnership during that tax year and that were related to the transferor during that tax year. See para

graph (i)(4) of this section for the definition of a related person;

(j) * * * (1) In general . Except as otherwise provided in this section, this section applies to transfers made on or after January 1, 1998. * * *

(3) Special rule for transfers made be- fore January 1, 2000 . Even if not reported in accordance with the rules provided in paragraph (a)(5) of this section, or paragraph (j)(1) or (2) of this section, a transfer that occurred before January 1, 2000 will nevertheless be considered timely reported if the transferor reports it on a Form 8865 attached to an amended tax return for the transferor’s tax year in which the transfer occurred, provided such amended return is filed no later than September 15, 2000.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 7. The authority citation for part

602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 8. In §1.602.101, paragraph (b) is amended by revising the entries for §1.6038-2, §1,6038(B)-1, and §1.6038B2 and adding an entry in numerical order to the table to read as follows: §602.101 OMB Control numbers.

(b) * * *

Robert Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 9, 1999.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on December 27, 1999, 8:45 a.m., and published in the issue of the Federal Register for December 28,1999, 64 F.R. 72545)

CFR part or section where Current OMB identified and described control No.

1.6038-2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1617 1.6038-3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1617

1.6038B-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1617

1.6038B-2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1617

Section 6046A.—Returns As To Interests In Foreign Partnerships

26 CFR 1.6046A–1:Return requirement for United States persons who acquire or dispose of an interest in a foreign partnership, or whose proportional interest in a foreign partnership changes substantially.

T.D. 8851

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Return Requirement for United States Persons Acquiring or Disposing of an Interest in a Foreign Partnership, or Whose Proportional Interest in a Foreign Partnership Changes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations under section 6046A of the Internal Revenue Code relating to the requirement that United States persons, in certain circumstances, file a return if they acquire or dispose of an interest in a foreign partnership, or if their proportional interest in a foreign partnership changes.

DATES: Effective Date: December 29, 1999. Applicability Dates: For dates of applicability of §1.6046A-1, see §1.6046A1(j).

2000–2 I.R.B. 275 January 10, 2000

FOR FURTHER INFORMATION CONTACT: Eliana Dolgoff, (202) 622-3860 (not a toll-free number). SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-1646. Responses to this collection of information are mandatory.

The burden of complying with the collection of information required to be reported on Form 8865 is reflected in the burden for Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships.”

Suggestions for reducing the burden associated with this rule should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer of the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Background

On September 9, 1998, the IRS published in the Federal Register (63 FR 48154(REG–209060–86, 1998–39 I.R.B. 18)) proposed regulations under section 6046A. A public hearing on the proposed regulations was held on November 10, 1998, even though no requests to speak at the hearing were received. Though no comments were made at the hearing, written comments were received. After consideration of all of the written comments, the proposed regulations under section 6046A are adopted as revised by this Treasury decision. The revisions are discussed below.

Explanation of Provisions and Summary of Comments

Commentators requested that section 6046A reporting not be required of United States persons that are indirect partners in a partnership. For example, a United States person would not be required to report under section 6046A with respect to an interest in a foreign partnership that the person owned indirectly through another partnership. Unlike section 6038, section 6046A reporting may apply with respect to any foreign partnership, not just foreign partnerships controlled by U.S. persons. Accordingly, the IRS agrees that reporting should not be required for indirect acquisitions, dispositions, and changes in proportional foreign partnership interests, because it would be burdensome and difficult for some partners to discover and keep track of such events. Additionally, if section 6046A reporting were required for changes in indirectly owned foreign partnership interests, then a transfer of an interest in one entity in a chain of entities at the bottom of which is a foreign partnership could result in multiple, duplicative, section 6046A reporting obligations.

Thus, the final regulations substantially reduce the burden section 6046A would have imposed on taxpayers under the proposed regulations. The final regulations provide that under §1.6046A-1(a)(1), a United States person is only required to report pursuant to section 6046A if that person has a “reportable event.” A person can only have a reportable event with respect to a particular foreign partnership if that person owns a direct interest in the partnership. More specifically, the United States person must acquire or dispose of a direct interest in the foreign partnership, or have a change in its direct proportional interest, in order to have a reportable event under section 6046A. See §1.6046A-1(b)(1).

Some commentators also requested that the final regulations exempt state and local government employee retirement plans from the section 6046A reporting requirements. The final regulations provide that trusts relating to state and local government employee retirement plans are not required to report under section 6046A, unless required to do so in the instructions to Form 8865, “Return of U.S. Persons With Respect To Certain Foreign Partnerships.” The IRS and Treasury invite com

ments regarding whether the section 6046A reporting obligation should also be reduced for other tax-exempt entities.

A United States person required to report information pursuant to section 6046A must do so by completing and filing Form 8865. A final version of Form 8865 will be released prior to January 1, 2000. Taxpayers will be able to download a copy of the form and its instructions from the IRS Internet website located at www.irs.ustreas.gov.

The final regulations apply to reportable events that occur on or after January 1, 2000. Acquisitions and dispositions of foreign partnership interests, and changes in proportional foreign partnership interests, occurring before January 1, 2000, are not required to be reported under section 6046A.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required.

This Treasury decision finalizes a notice of proposed rulemaking published September 9, 1998. It has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to the final regulations issued pursuant to the notice of proposed rulemaking published on September 9, 1998. It is hereby certified that this Treasury decision will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that the amount of time required to complete the form and file the information required under these regulations is brief and will not have a significant impact on those small entities that are required to provide notification. Furthermore, the number of small entities that will be required to file the form is not substantial. Accordingly, 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, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

January 10, 2000 276 2000–2 I.R.B.

interests resulting from a partner withdrawing from the partnership. A proportional change may also occur by operation of the partnership agreement, for example, if the partnership agreement provides that a partner’s interest in profits will change on a set date or when the partnership has earned a specified amount of profits and one of those events occurs.

(4) Ten-percent interest . Under section 6046A(d) and this section, a ten-percent interest in a foreign partnership, as described in section 6038(e)(3)(C) and the regulations thereunder, means an interest equal to ten percent of the capital interest in such partnership, an interest equal to ten percent of the profits interest in such partnership, or an interest to which ten percent of the deductions or losses of such partnership are allocated.

(5) United States person . United States person means a person described in section 7701(a)(30).

(6) Foreign partnership . Foreign part- nership means any partnership that is a foreign partnership under sections 7701(a)(2) and (5). (7) Examples . The rules of paragraph (a) of this section and this paragraph (b) are illustrated by the following examples:

Example 1. Acquisition of an indirect interest . FP, a foreign partnership, has two partners, FC1 and FC2, both foreign corporations. FC1 owns a 40% interest in FP, and FC2 owns a 60% interest in FP . No United States person owns an interest in FP, either directly, or constructively under section 6038(e)(3)(C) and section 267(c). On January 1, 2001, US, a United States person and calendar year taxpayer, acquires by purchase 100% of FC2 ’s stock. US has acquired an indirect interest of 60% in FP . See sections 6038(e)(3)(C) and 267(c)(1). However, US is not required to report the January 1, 2001 indirect acquisition under section 6046A. US did not own a 10% or greater direct interest in FP before the acquisition, and US does not own a 10% or greater direct interest as a result of the acquisition. (US must, however, comply with the reporting requirements under section 6038 (controlled foreign corporation and controlled foreign partnership reporting) with respect to FC2 and FP .)

Example 2 . Acquisition of direct interests . (i) Assume the same facts as Example 1 . In addition, on June 1, 2001, US purchases a 5% direct interest in FP from FC1 . US did not own a 10% or greater direct interest in FP before the acquisition. After the acquisition, US does not own a direct interest of 10% or more. US owns a 10% or greater total interest (direct and indirect), but only a 5% direct interest. Therefore, US is not required to report the June

Drafting Information

The principal author of these final regulations is Eliana Dolgoff of the Office of Associate Chief Counsel (International). However, other personnel from the IRS and the Treasury Department participated in their development.

Amendments to the Regulations

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

PART 1—INCOME TAXES

Par. 1. The authority citation for part 1 is amended by adding an entry in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.6046A-1 also issued under 26 U.S.C. 6046A. * * * Par. 2. Section 1.6046A-1 is added to read as follows:

§1.6046A-1 Return requirement for United States persons who acquire or dis- pose of an interest in a foreign partner- ship, or whose proportional interest in a foreign partnership changes substantially .

(a) Return requirement —(1) General rule . If a United States person has a reportable event (as defined in paragraph (b)(1) of this section) during the person’s tax year, then, except as provided in paragraph (f) of this section, the United States person is required to complete and file Form 8865, “Return of U.S. Persons With Respect To Certain Foreign Partnerships,” containing the information described in paragraph (c) of this section.

(2) Separate return for each partner- ship . If a United States person has a reportable event with respect to an interest in more than one foreign partnership, the United States person must file a separate Form 8865 for each foreign partnership.

(b) Definitions —(1) Reportable event . There are three categories of reportable events under section 6046A: acquisitions, dispositions, and changes in proportional interests.

(i) Acquisitions . A United States person that acquires a foreign partnership interest has a reportable event if—

(A) The person did not own a ten-percent or greater direct interest in the partnership and as a result of the acquisition the person owns a ten-percent or greater

direct interest in the partnership. For purposes of this paragraph (b)(1)(i)(A), an acquisition includes an increase in a person’s direct proportional interest; or

(B) Subject to paragraph (b)(2) of this section, compared to the person’s direct interest when the person last had a reportable event, after the acquisition the person’s direct interest has increased by at least a ten-percent interest.

(ii) Dispositions . A United States person that disposes of a foreign partnership interest has a reportable event if—

(A) The person owned a ten-percent or greater direct interest in the partnership before the disposition and as a result of the disposition the person owns less than a ten-percent direct interest. For purposes of this paragraph (b)(1)(ii)(A), a disposition includes a decrease in a person’s direct proportional interest; or

(B) Subject to paragraph (b)(2) of this section, compared to the person’s direct interest when the person last had a reportable event, after the disposition the person’s direct interest has decreased by at least a ten-percent interest.

(iii) Changes in proportional interests not otherwise reportable as acquisitions or dispositions under paragraph (b)(1)(i)(A) or (b)(1)(ii)(A) of this section . A United States person has a reportable event if, subject to paragraph (b)(2) of this section, compared to the person’s direct proportional interest the last time the person had a reportable event, the person’s direct proportional interest has increased or decreased by at least the equivalent of a ten-percent interest.

(2) Special rule for foreign partnership interests owned on December 31, 1999 . If a United States person owned a ten-percent or greater direct interest in a foreign partnership on December 31, 1999, then to determine whether the person has a reportable event under paragraph (b)(1)(i)(B), (b)(1)(ii)(B), or (b)(1)(iii) of this section, the comparison should be made to the person’s direct interest on December 31, 1999. Once the person has a reportable event after December 31, 1999, future comparisons should be made by reference to the last reportable event.

(3) Change in a proportional interest . A partner’s proportional interest in a foreign partnership may change for a number of reasons, for example, the change may be caused by changes in other partners’

2000–2 I.R.B. 277 January 10, 2000

1, 2001, acquisition under section 6046A. (ii) On September 1, 2001, US purchases a 7% direct interest in FP from FC1 . The September 1, 2001 acquisition constitutes a reportable event under paragraph (b)(1)(i)(A) of this section. Before the September 1 acquisition, US did not own a 10% or greater direct interest in FP . After the September 1 acquisition, US owns a 12% direct interest, and therefore, as a result of the September 1 acquisition, US now owns a 10% or greater direct interest in FP . Consequently, US must report its September 1 acquisition under section 6046A on Form 8865 filed with US ’s 2001 income tax return.

(iii) On December 1, 2001, US acquires an additional 4% direct interest in FP from FC1, so that US ’s total direct interest has increased from 12% to 16%. This acquisition does not constitute a reportable event. Compared to US ’s direct interest when US last had a reportable event (12% on September 1, 2001), after acquiring the 4% interest US ’s direct interest has not increased by at least a 10% direct interest (i.e., its direct interest increased by only 4%). Therefore, US does not have to report the December 1, 2001, acquisition under section 6046A. On April 1, 2002, FC2 distributes a 6% direct interest in FP to US . US now owns a 22% direct interest in FP . Compared to US ’s direct interest when US last had a reportable event (12% on September 1, 2001), after the April 1 acquisition US ’s direct interest has increased by at least a 10% interest (12% to 22%). US must report the April 1, 2002 acquisition on a Form 8865 attached to US ’s 2002 income tax return.

Example 3. Change in proportional interest re- sulting from withdrawal of a partner. Assume the same facts as Example 3 . In addition, on January 5, 2003, FC2 withdraws entirely from FP . As a result, the direct interests of US and FC1 in FP each increase by at least the equivalent of 10% interests. Compared to US ’s direct interest the last time US had a reportable event (22% on April 1, 2002), US ’s direct interest has increased by at least the equivalent of a ten percent interest. Therefore, US has had a reportable event pursuant to paragraph (b)(1)(iii) of this section, and US must report the change in its interest resulting from FC2 ’s withdrawal from the partnership on US ’s Form 8865 filed with US ’s 2003 tax year income tax return.

E xample 4. Change in proportional interest con- stituting an acquisition. FP is a foreign partnership that has no United States persons as direct or constructive partners. US is a United States person and a calendar year taxpayer. On January 1, 2001, US purchases an 8% direct interest in FP . US is not required to report this acquisition. US did not own a 10% or greater direct interest in FP, and US does not own a 10% or greater direct interest as a result of the acquisition. On March 1, 2001, FC, a foreign part

ner of FP, withdraws from FP, and as result, US ’s direct interest in FP increases by a 7% interest. The increase in US ’s direct interest is considered an acquisition of an interest under paragraph (b)(1)(i)(A) of this section. US did not own a 10% or greater direct interest in FP before FC withdrew, and as a result of the increase in US ’s direct interest because of FC ’s withdrawal from FP, US now owns a 10% or greater direct interest in FP . Therefore, US must report under section 6046A the increase in US ’s direct interest resulting from the withdrawal of FC from FP on Form 8865 filed with US ’s tax return for US ’s 2001 tax year. (c) Content of return . The Form 8865 that must be filed under paragraph (a)(1) of this section must contain the following information in such form and manner and to the extent that Form 8865 and its instructions prescribe—

(1) The name, address, and taxpayer identification number of the United States person required to file the return;

(2) Information about other persons (foreign or domestic) whose interests in the foreign partnership the person reporting under section 6046A is considered to own under section 6038(e)(3)(C) and section 267(c);

(3) Information about all foreign entities that were disregarded as entities separate from their owners under §§301.77012 and 301.7701-3 of this chapter that were owned by the foreign partnership during the partnership’s tax year ending with or within the tax year of the person filing Form 8865 pursuant to section 6046A;

(4) For each reportable event, the date of the event, the type of event (acquisition, disposition, or change in proportional interest), and the United States person’s direct percentage interest in the foreign partnership immediately before and immediately after the event;

(5) The fair market value of the interest acquired or disposed of;

(6) Information about partnerships (foreign and domestic) in which the foreign partnership owned a direct interest, or a constructive interest of ten percent or more under sections section 267(c)(1) and (5) and the regulations thereunder, during the partnership’s tax year ending with or within the tax year of the person filing Form 8865 pursuant to section 6046A; and

(7) Any other information required to be submitted by Form 8865 and its instructions.

(d) Time and manner for filing returns . The Form 8865 must be filed with the timely filed (including extensions) income tax return of the United States person for the tax year in which the reportable event occurs. If the United States person is not required to file an income tax return for its tax year in which the reportable event occurs, but is required to file an information return for that year (for example, Form 1065, “U.S. Partnership Return of Income,” or Form 990, “Return of Organization Exempt from Income Tax”), the United States person should attach the Form 8865 to its information return filed for that tax year.

(e) Duplicate returns . If required by the instructions to Form 8865, a duplicate Form 8865 (including attachments and schedules) must also be filed.

(f) Persons excepted from filing return —(1) Section 6038B overlap . If a United States person acquires an interest in a foreign partnership as a result of a section 721 contribution required to be reported under section 6038B, and the person properly reports the contribution under section 6038B, then the United States person is not required to report the acquisition of the partnership interest under section 6046A(a) should it constitute a reportable event under paragraph (b)(1) of this section. The acquisition will still constitute a reportable event for purposes of making future comparisons pursuant to paragraphs (b)(1)(i)(B), (b)(1)(ii)(B) and (b)(1)(iii) of this section. A person that fails to properly report the section 721 contribution under section 6038B and the regulations thereunder and that fails to properly report the acquisition of the partnership interest under section 6046A may be subject to the penalties applicable to a failure to comply with the requirements of section 6038B, as well as the penalties applicable for a failure to comply with the requirements of section 6046A. See paragraph (h) of this section for more information about the penalties for failure to comply with the requirements of section 6046A.

(2) Trusts relating to state and local government employee retirement plans . The return requirement of section 6046A does not apply to trusts relating to state and local government employee retirement plans, unless the instructions to Form 8865 provide otherwise.

January 10, 2000 278 2000–2 I.R.B.

(3) Reporting under this section not required of partnerships excluded from the application of subchapter K . The reporting requirements of this section will not apply to any United States person in respect of an eligible partnership as described in §1.761-2(a) in which that United States person is a partner, if such partnership has validly elected to be excluded from all of the provisions of subchapter K of chapter 1 of the Internal Revenue Code in the manner specified in §1.761-2(b)(2)(i), or is deemed to have elected to be excluded from all of the provisions of subchapter K of chapter 1 of the Internal Revenue Code in accordance with the provisions of §1.7612(b)(2)(ii). (4) Exclusion for satellite organiza- tions . The return requirement of section 6046A does not apply to the International Telecommunications Satellite Organization (or a successor organization) or the International Maritime Satellite Organization (or a successor organization).

(g) Method of reporting . Except as oth

erwise provided on Form 8865, or the accompanying instructions, any amounts required to be reported under section 6046A and this section must be expressed in United States dollars, with a statement of the exchange rates used. All statements required on or with Form 8865 pursuant to this section must be in English.

(h) Penalties for violating section 6046A . For penalties for violating section 6046A, see sections 6679 and 7203. (i) Statute of limitations . For exceptions to the limitations on assessment in the event of a failure to provide information under section 6046A, see section 6501(c)(8). (j) Effective date . This section applies to reportable events occurring after December 31, 1999. No reporting under section 6046A is required for reportable events occurring on or before December 31, 1999.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3 The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 4 In §602.101, paragraph (b) is amended by adding an entry in numerical order to the table to read as follows: §602.101 OMB Control numbers.

(b) * * *

Robert Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 9, 1999.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on December 27, 1999, 8:45 a.m., and published in the issue of the Federal Register for December 28, 1999, 64 F.R. 72555)

CFR part or section where Current OMB identified and described control No.

1.6046A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1646

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of January 2000. See Rev. Rul. 2000–1, page 250.

Section 7872.—Treatment of Loans with Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of January 2000. See Rev. Rul. 2000–1, page 250.

2000–2 I.R.B. 279 January 10, 2000