Daily Tax Update - February 22, 2005

Treasury and IRS Issue Final Regulations on Adjustments to Net Unrealized Built-in Gain of S Corporations
Today, the IRS and the Treasury issued final regulations that would provide guidance on how Section 1374 applies to certain cases where an S corporation acquires assets from a C corporation in a carryover basis transaction in which the basis in the stock of the C corporation is eliminated. In general, the final regulations require an S corporation, for purposes of Section 1374, to adjust its net unrealized built-in gain ("NUBIG") to eliminate the effect of any built-in gain or built-in loss in stock that (i) entered initially into the computation of NUBIG and (ii) is redeemed or canceled in a carryover basis transaction in which the basis of such stock is eliminated (e.g., a liquidation by an S corporation of its wholly owned C corporation in a transaction described in Sections 332 and 337 or an acquisition by an S corporation of the assets of a C corporation in a reorganization described in Section 368).

  • The final regulations adopt regulations proposed in June 2004 without substantive changes. However, the final regulations modify the proposed effective date of the regulations. The final regulations generally apply to specified carryover basis transactions (referred to in the preamble as "section 1374(d)(8) transactions") that occur in taxable years beginning after the date the final regulations are published in the Federal Register (i.e. February 23, 2005).
  • However, the final regulations also provide that an S corporation may apply the final regulations to section 1374(d)(8) transactions that occur in taxable years beginning on or before the date the final regulations are published in the Federal Register (i.e. February 23, 2005), "if the S corporation (and any predecessors or successors) and all affected shareholders file original or amended returns that are consistent with these provisions for taxable years of the S corporation during the recognition period of the pool of assets the net unrealized built-in gain of which would be adjusted pursuant to those provisions that are not closed as of the first date after [the date the final regulations are published in the Federal Register] that the S corporation files an original or amended return."
  • For additional information, contact Mark J. Silverman via email or Aaron P. Nocjar via email.

UNICAP Regs Finalized Dealing with Safe Harbor Leasing Interest
Treasury and IRS today finalized without change regulations proposed in May 2004 addressing certain issues under the uniform capitalization rules. Specifically, the regulations finalize a proposal to treat as "eligible debt" a purchase money obligation given by the lessor to the lessee (or a party related to the lessee) in a safe harbor sale leaseback under section 168(f)(8).

  • Treating such debt as "eligible debt" effectively excludes it from the class of debt that must be capitalized under the avoided cost method of interest capitalization under section 263A.
  • The rules are effective for interest incurred in taxable years beginning on or after May 20, 2004. In the case of property that is inventory in the hands of the taxpayer, the rule applies to taxable years beginning on or after May 20, 2004. Taxpayers may elect to apply the rule to interest incurred in taxable years beginning on of after January 1, 1995 or, in the case of property that is inventory in the hands of the taxpayer, to taxable years beginning on of after January 1, 1995.
  • A change in a taxpayer's treatment of interest to a method consistent with this rule is a change in method of accounting to which sections 446 and 481 apply. Because the position articulated in the regulations is deemed to be a reasonable position for the application of section 263A(f) in prior periods, a taxpayer changing a method of accounting for property that is not inventory in the hands of the taxpayer to conform to the regulations may elect to include interest incurred after December 31, 1986 (the effective date of section 263A) and before January 1, 1995, in the determination of its adjustment under section 481(a). A taxpayer changing a method of accounting for property that is inventory in the hands of the taxpayer to conform to the regulations must compute a section 481 adjustment and revalue its beginning inventory in the year of change as if the new method of accounting had been in effect during all prior periods
  • For additional information, contact Philip R. West via email or J. Walker Johnson via email.

IRS Announces Settlement Offer for Executive Stock Option Schemes
Today, the IRS announced a settlement initiative for executives and companies that participated in an abusive tax avoidance transaction involving the transfer of stock options or restricted stock to family controlled entities.

  • According to the IRS, "Under this scheme, executives, often facilitated by their corporate employers, transferred stock options to family controlled partnerships and other related entities typically created for the sole purpose of receiving the options and avoiding taxes on compensation income normally taxed to the executive. The tax objective was to defer for up to 30 years taxes on the compensation and, in many cases, resulted in the corporation deferring a legitimate deduction for the same compensation." The IRS said that it has identified 42 corporations to date with many more executives and unreported income of more than $700 million involved in this scheme. The IRS said that corporate executives who engaged in these transactions will have until May 23, 2005, to accept an IRS settlement offer to resolve their tax issues. The offer also extends to corporations that issued the options to executives and directors as part of their compensation.
  • IRS Commissioner Mark Everson said, "These transactions raise questions not only about compliance with the tax laws, but also, in some instances, about corporate governance and auditor independence. These deals were done for the personal benefit of executives, often at the expense of shareholders." Everson added, "We believe a new climate under Sarbanes-Oxley, together with the tougher independence standards for auditors recently proposed by the Public Company Accounting Oversight Board make this sort of thing less likely going forward. However, we want to give executives and corporations a chance to clean up past transactions."
  • For additional information, contact Anne E. Moran via email.
  • The IRS release can be accessed here.

STEPTOE & JOHNSON LLP - TAX PRACTICE
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