United States: Solutions for Issues Regarding S Corporations and Their Shareholders Include Congressional Action, Revised Guidance From Treasury

Originally published August 31, 2002

There are a number of important S corporation issues that need to be resolved quickly by the Treasury Department.

The first issue involves the application of Section 1374 to a Section 332 liquidation of a subsidiary owned by an S corporation. Under Section 1374, a C corporation that converts to an S corporation must calculate its net unrealized built-in gain (NUBIG) at the time of conversion. See Section 1374(d)(1); Treasury Regulations §1.1374-3. The S corporation generally must pay a corporate level tax on any built-in gain (BIG) recognized on the sale of these assets during the ten-year period following conversion. See Section 1374(a).

When a C corporation that owns a subsidiary converts to an S corporation (but does not liquidate the subsidiary or convert the subsidiary to a qualified subchapter S subsidiary (Qsub)), NUBIG is determined with respect to the BIG inherent in the stock of the subsidiary. In a subsequent year when the subsidiary liquidates or converts to a Qsub in a transaction to which Sections 332 and 337 apply, the assets of the subsidiary also become subject to Section 1374 and such assets create a second NUBIG (i.e., a separate NUBIG is determined solely with respect to the assets of the subsidiary). See Section 1374(d)(8); Treas. Reg. §1.1374-8.

Unfortunately, the BIG in the stock of the subsidiary may remain in the originally determined NUBIG. As a result, the S corporation may pay Section 1374 tax with respect to the same BIG twice.

To resolve this problem, NUBIG should be adjusted for the amount of gain or loss realized, but not recognized, by an S corporation upon the liquidation of its subsidiary that is attributable to the period prior to the subsidiary's stock being taken into account for purposes of the originally determined NUBIG. Alternatively, an S corporation should adjust, but not below zero, its NUBIG by the amount of BIG or built-in loss in the stock of such subsidiary owned by the S corporation that existed on the date of conversion to S corporation status.

It appears appropriate that this problem may be addressed adequately and expeditiously through a published ruling. As a result, included is a draft revenue ruling. For purposes of demonstrating an alternative approach to solving this problem, also included is a proposed regulatory solution.

The second issue involves the application of the alternative minimum tax (AMT) rules to the distribution rules for S corporations and their shareholders.

An S corporation (which was formerly a C corporation with C corporation accumulated earnings and profits) that generates, for example, $100 of investment income and $100 of investment expense produces zero taxable income for its shareholders for purposes of the regular tax. See Sections 1, 63, 212, 1366.

However, Section 56(b)(1)(A)(i) denies a deduction for the $100 of investment expense for purposes of the AMT tax. As a result, the S corporation produces $100 of alternative minimum taxable income (AMTI) for its shareholders. When an S corporation makes cash distributions in order to allow its shareholders to pay the AMT tax generated by this AMTI, the distributions will create additional AMTI (which, in turn, creates additional AMT tax).

This problem may be addressed in two ways. Congress could repeal or limit the application of Section 56(b)(1)(A)(i). Alternatively, the Treasury Department could clarify that the separate, yet parallel, concept of the AMT requires that:

• an S corporation maintain an AMT accumulated adjustments account (AAA), and

• S corporation shareholders maintain separate AMT bases in S corporation stock and debt.

The latter proposal permits S corporations to make distributions to pay AMT tax without generating additional tax.

An in-depth description of the S corporation issues and proposed solutions follows.

Problem: The application of Section 1374 to a complete liquidation of an S corporation's C corporation subsidiary to which Section 332 applies duplicates net recognized built-in gain.

Solution: A. The following amendment to Treas. Reg. §1.1374-8 provides that gain or loss realized, but not recognized, by an S corporation in a complete liquidation to which Section 332 applies adjusts the NUBIG attributable to the assets that include the stock exchanged, cancelled or redeemed in the complete liquidation.

As a result, the potential for gain or loss recognition attributable to the stock of the corporation that is completely liquidated only continues in its liquidated assets and the potential for such gain or loss recognition is not duplicated by continuing in the remaining assets of the S corporation.

B. Pursuant to Section 1374(e), redesignate current Treas. Reg. §1.1374-8(d) as new Treas. Reg. §1.1374-8(e) and add the following language as new Treas. Reg. § 1.1374-8(d):

C. Pursuant to Section 1374(e), redesignate current Treas. Reg. §1.1374- 10(b) as new Treas. Reg. §1.1374-10(c), insert "Except as otherwise provided in paragraph (b) of this section," as the first phrase of the first sentence in current Treas. Reg. §1.1374-10(a), and add the following effective date language as new Treas. Reg. §1.1374-10(b):

Rationale: A. S Corporations With Controlled Subsidiaries. Prior to 1997, a corporation owning stock representing 80 percent or more of the vote and value of another corporation was not eligible to elect subchapter S status. See Section 1361(b)(2)(A) (1996). Consistent with this pre-1997 rule, Section 1374 does not incorporate the application of Section 332 and Section 337 to the liquidation of an S corporation's C corporation subsidiary.

With respect to tax years beginning after 1996, Congress amended Section 1361 to permit corporations that own 80 percent or more of the stock of a C corporation to elect subchapter S status. See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, §§1308(a), 1317(a), 110 Stat. 1755, 1782, 1787 (1996) (hereinafter "the 1996 Act") (removing from the definition of an "ineligible corporation" a member of an affiliated group).

However, the 1996 Act did not amend Section 1374 to take into account the amendment to Section 1361. Congress made the last relevant amendment to Section 1374 in 1989. See Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, §7811(c)(5)(B), 103 Stat. 2106, 2407 (1989); Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, §1006(f)(5)(A), 102 Stat. 3342, 3404 (1988); Tax Reform Act of 1986, Pub. L. No. 99-514, § 632(a), 100 Stat. 2085, 2275 (1986).

Furthermore, except for a timing issue with respect to Qsub elections for a tiered group of subsidiaries, the Treasury Department has not amended the regulations under Section 1374 since 1994. See T.D. 8869 (Jan. 20, 2000); T.D. 8579 (Dec. 23, 1994).

Thus, a regulatory amendment is needed to take into account the effect that the 1996 amendment to Section 1361 has on the application of Section 1374 to the liquidation of an S corporation's C corporation subsidiary under Section 332 and Section 337.

B. Hypothetical. General Facts: A corporation (Parent) owns three assets (the Original Assets). Asset #1 has $100 of BIG. Asset #2 has $100 of built-in loss (BIL). Asset #3 has $100 of BIG. Asset #3 represents all the stock in a C corporation subsidiary (Sub). Sub owns one asset (SubAsset) with $100 of BIG.

Year 1: Parent elects to be treated as a subchapter S corporation effective January 1, Year 1. Parent does not elect to treat Sub as a Qsub.

Year 2: The stock of Sub appreciates to create $110 of BIG because SubAsset appreciates to create $110 of BIG. Parent liquidates Sub on December 31, Year 2 in a transaction that qualifies under Section 332 and Section 337.

Year 3: Parent recognizes $100 of gain from the sale of Asset #1 and Parent recognizes $110 of gain from the sale of SubAsset.

C. Analysis Of Hypothetical. Year 1: As a result of Parent's election to be treated as an S corporation effective January 1, Year 1, Parent has a NUBIG attributable to Asset #1, Asset #2 and Asset #3 of $100 (Original NUBIG). See Section 1374(d)(1).

Year 2: As a result of Parent's complete liquidation of Sub, $110 of gain is realized, but not recognized, and the basis of SubAsset in the hands of Sub carries over to Parent. See Sections 331(c), 332, 334(b), 1001. Solely with respect to SubAsset, Parent has a second NUBIG equal to $110 (Liquidation NUBIG) and a second ten-year recognition period starts upon Sub's liquidation. See Section 1374(d)(8). Neither Section 1374 nor the Treasury regulations thereunder provide for an adjustment to Original NUBIG upon the liquidation of Sub.

Year 3: As a result of Parent's disposition of SubAsset, Parent takes into account $110 of net recognized built-in gain (NRBIG) because Parent's Liquidation NUBIG is $110. See Section 1374(d)(8). As a result of Parent's disposition of Asset #1, Parent takes into account another $100 of NRBIG because Parent's Original NUBIG is not decreased for any amount of gain realized, but not recognized, on the liquidation of Sub.

Overall: The $100 of Original NUBIG inherent in the Original Assets of Parent on January 1, Year 1 ultimately creates $200 of NRBIG because (i) the same $100 of unrealized gain (attributable to Sub and its asset) creates the majority of another NUBIG, i.e., $100 of the $110 Liquidation NUBIG, and (ii) Original NUBIG is not decreased upon the liquidation of Sub.

If Original NUBIG decreased by the amount of gain realized, but not recognized, upon the liquidation of Sub that is attributable to the period prior to Sub's stock being taken into account for Original NUBIG ($100), a more reasonable outcome would result. The NRBIG from the sale of Asset #1 would be $0 because new Treas. Reg. §1.1374-8(d) would have reduced Original NUBIG by $100 to $0.

As a result, the $100 of Original NUBIG inherent in the Original Assets of Parent would not be duplicated. Overall, $100 of NRBIG effectively would result from the Original NUBIG inherent in the Original Assets and $10 of NRBIG effectively would result from the additional BIG in SubAsset created in Year 2.

D. Effective Date. The effective date provisions are drafted to serve two purposes:

• to require S corporations that have unused NUBIG on the date of issuance to adjust NUBIG by the amounts of unrealized gain or loss that would have adjusted such NUBIG if the above regulatory amendment had been originally issued with the same effective date as The 1996 Act, and

• to prohibit S corporations from seeking a refund of NRBIG tax that would not have been payable if the above regulatory amendment had been originally issued with the same effective date as The 1996 Act.

Built-in gains tax. This ruling provides that an S corporation adjusts its net unrealized built-in gain for the amount of built-in gain or built-in loss in stock of a C corporation subsidiary that liquidates in a transaction to which section 332 of the Code applies. At the time of the liquidation, the S corporation adjusts, but not below zero, its net unrealized built-in gain by the amount of built-in gain or built-in loss in the stock of such subsidiary that existed on the date of conversion to S corporation status.

Should an S corporation adjust its net unrealized built-in gain for the amount of built-in gain or built-in loss in the stock of its C corporation subsidiary upon the liquidation of that subsidiary in a transaction to which §332 of the Internal Revenue Code applies?

FACTS

A C corporation ("Parent") elects to be treated as an S corporation effective January 1, Year 1. On the date of Parent's conversion to S status, Parent owns three assets (the "Original Assets"). Asset #1 has an adjusted basis of zero and a fair market value of $100x. Asset #2 has an adjusted basis of $100x and a fair market value of zero. Asset #3 has an adjusted basis of zero and a fair market value of $100x. Thus, the amount by which the fair market value of Parent's assets as of January 1, Year 1 exceeds the aggregate adjusted bases of such assets at such time (Parent's "net unrealized built-in gain" under §1374(d)(1)) is $100x.

Asset #3 consists of all the stock of a C corporation ("Sub"). Sub owns one asset ("SubAsset"), which has an adjusted basis of zero and a fair market value of $100x. For business reasons, Parent does not elect to treat Sub as a qualified subchapter S subsidiary at the time of Parent's conversion to S status.

In Year 2, the fair market value of SubAsset increases by $10x, increasing the built-in gain in SubAsset from $100x to $110x. As a result, the fair market value of the stock of Sub increases by $10x, increasing the built-in gain in the stock of Sub from $100x to $110x. Parent liquidates Sub on December 31, Year 2 in a transaction that qualifies under §§332 and 337.

In Year 3, Parent sells Asset #1 for $100x, recognizing $100x of gain on the sale. In the same year, Parent sells SubAsset for $110x, recognizing $110x of gain on the sale.

Section 1374 generally provides that if a C corporation converts to an S corporation, the S corporation must pay a corporate-level tax on its net recognized built-in gain arising from the disposition of S corporation assets during the ten-year period following its conversion to S corporation status (i.e., the recognition period). See §1374(a). However, the S corporation's aggregate amount of net recognized built-in gain is limited to the aggregate net built-in gain that existed on the date of conversion to S corporation status (i.e., the S corporation's net unrealized built-in gain). See §1374(c)(2); see also H.R. Conf. Rep. No. 99-841, at II-203.

Congress enacted §1374 to support the repeal of the General Utilities doctrine. See H.R. Conf. Rep. No. 99-841, at II-198 to II-203 (1986); Staff of the J. Comm. on Taxation, 99 th Cong., General Explanation of the Tax Reform Act of 1986 339, 344-45 (Comm. Print 1987). The structure of §1374 indicates that, for purposes of calculating an S corporation's net recognized built-in gain and net unrealized built-in gain, Congress assumed that an S corporation eventually would dispose of assets subject to §1374 in (i) transactions in which the S corporation could recognize gain or loss or (ii) nonrecognition transactions in which the S corporation would transfer assets subject to §1374 in exchange for assets that succeeded to the bases of the transferred assets (e.g., a transfer described in §§721 or 351) ("exchanged basis property").

Section 1374(d)(1) defines "net unrealized built-in gain" as the amount by which the fair market value of the assets of the S corporation as of the beginning of its first taxable year as an S corporation exceeds the aggregate adjusted bases of such assets at such time. Sections 1374(d)(2), 1374(d)(3), and 1374(d)(4) generally define "net recognized built-in gain," "recognized built-in gain," and "recognized built-in loss," respectively, in connection with sale or exchange transactions that trigger the recognition of gain or loss. See also §1.1374-4(a) of the Income Tax Regulations. Section 1374(d)(5) generally applies to transactions that cause an S corporation to take into account a built-in income item or a built-in deduction item (e.g., the collection of an account receivable by a cash-method S corporation), and provides that an S corporation must adjust its net unrealized built-in gain for built-in income items and built-in deduction items that eventually could be taken into account by the S corporation. Section 1374(d)(6) ensures that exchanged basis property is subject to §1374 to the same extent as the property that the S corporation transferred in exchange for the exchanged basis property. Thus, the structure of §1374 indicates that Congress assumed that an S corporation eventually would dispose of assets subject to §1374 (or assets that received exchanged bases from assets originally subject to §1374) in transactions in which the S corporation could recognize gain or loss. See also Section 1.1374-3(a) (indicating that an S corporation must determine its net unrealized built-in gain under the assumption that it eventually will dispose of, or take into account, its assets subject to §1374 (or assets that receive exchanged bases from assets originally subject to §1374) in transactions in which the S corporation could recognize gain or loss).

Prior to 1997, a corporation generally did not qualify (or ceased to qualify) as an S corporation if the corporation owned stock representing 80 percent or more of the vote and value of another corporation. See §1361(b)(2)(A) (1996). As a result, prior to 1997, an S corporation generally could not liquidate a C corporation subsidiary in a transaction to which §§332 and 337 applied. See §332(b)(1). With respect to tax years beginning after 1996, Congress amended §1361 to permit a corporation that owns 80 percent or more of the stock of a C corporation to elect S corporation status. See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, §§1308(a), 1317(a), 110 Stat. 1755, 1782, 1787 (1996). Therefore, an S corporation now may own 80 percent or more of the stock of a C corporation subsidiary, and thus may liquidate a C corporation subsidiary in a transaction to which §§332 and 337 apply.

If a corporation converts to S status and owns a C corporation subsidiary at the time of the conversion, the stock of the subsidiary is an asset that is taken into account for purposes of determining the S corporation's net unrealized built-in gain. The subsequent liquidation of an S corporation's C corporation subsidiary in a transaction to which §332 applies eliminates that asset. Section 332 treats the S corporation as exchanging the stock of the C corporation subsidiary for the assets of the C corporation subsidiary in a transaction in which gain or loss is not recognized. Furthermore, §334(b) provides that the basis of the stock of the C corporation subsidiary does not carry over into the former assets of the C corporation subsidiary for purposes of determining the S corporation's bases in such assets. The stock of the C corporation subsidiary thus is eliminated in a transaction in which (i) gain or loss is not recognized and (ii) the S corporation does not receive exchanged basis assets. As a result, any built-in gain or built-in loss attributable to the stock of the C corporation subsidiary disappears. Accordingly, the S corporation must eliminate such stock's effect on the application of §1374 by adjusting, but not below zero, its net unrealized built-in gain by the amount of built-in gain or built-in loss in the stock of such subsidiary that existed on the date of conversion to S corporation status. With respect to the assets received by the S corporation from the liquidating C corporation, the S corporation has a separate net unrealized built-in gain with a separate ten-year recognition period, which starts upon the C corporation's liquidation. See §1374(d)(8).

Under the facts of this ruling, as a result of Parent's election to be treated as an S corporation effective January 1, Year 1, Parent has a net unrealized built-in gain attributable to Asset #1, Asset #2, and Asset #3 of $100x ("Original NUBIG"). As a result of Parent's complete liquidation of Sub in Year 2, Parent realizes $110x of gain, but such gain is not recognized pursuant to §332. The basis of SubAsset in the hands of Sub carries over to Parent pursuant to §334(b). Solely with respect to SubAsset, Parent has a separate net unrealized built-in gain equal to $110x ("Liquidation NUBIG") and a separate ten-year recognition period, which starts upon Sub's liquidation pursuant to §1374(d)(8).

Because Sub is liquidated in a transaction to which §332 applies, the stock of Sub (Asset #3) is eliminated in a transaction in which (i) gain or loss is not recognized and (ii) Parent does not receive exchanged basis assets. Accordingly, Parent eliminates such stock's effect on the application of §1374 by adjusting, but not below zero, Parent's net unrealized built-in gain by the amount of built-in gain or built-in loss in the stock of Sub that existed on the date of conversion to S corporation status.

As a result, Parent decreases its Original NUBIG by $100x (the amount of built-in gain in the stock of Sub that existed on the date of Parent's conversion to S corporation status). Thus, the net recognized built-in gain from the sale of Asset #1 in Year 3 is $0x because Parent reduces its Original NUBIG by $100x (from $100x to $0x) in Year 2. Parent's sale of SubAsset in Year 3 causes Parent to recognize $110x of gain. Parent must take into account the full amount of that $110x of gain as net recognized built-in gain under §1374.

An S corporation adjusts its net unrealized built-in gain for the amount of built-in gain or built-in loss attributable to stock of its C corporation subsidiary owned by the S corporation upon the liquidation of that C corporation subsidiary in a transaction to which §332 applies. At the time of the liquidation, the S corporation adjusts, but not below zero, its net unrealized built-in gain by the amount of built-in gain or built-in loss in the stock of such subsidiary that existed on the date of conversion to S corporation status.

Problem: Distributions to pay alternative minimum tax are treated as dividends.

Hypothetical. An S corporation that was formerly a C corporation with $100 of accumulated earnings and profits (AEP) from its C corporation years has a single individual shareholder (A). A has zero basis in the stock of the S corporation.

In its first year as an S corporation, the S corporation has $100 of investment income and $100 of investment expense (which is not deductible for AMT purposes under Section 56(b)(1)(A) ). For regular tax purposes, A has zero taxable income. For AMT purposes, A has $100 of alternative minimum taxable income (AMTI) because the AMT denies A the regular tax benefit generated by the investment expense.

As a result, A has $28 of AMT tax even though A realizes zero economic income (assuming that only the 28 percent AMT tax rate applies to A and A's AMT exemption amount is zero). See Section 55(b). In order for A to pay the AMT tax, the S corporation distributes $28 to A. The distribution is treated as a dividend because the S corporation's accumulated adjustments account (AAA) is zero and the S corporation has subchapter C AEP. See Section 1368(c)(2).

Thus, the distribution causes A to have $28 of additional AMTI, resulting in additional AMT tax.¹ To enable A to pay the additional AMT tax, the S corporation "grosses up" the distribution to $39. The gross-up amount is also additional AMTI and itself results in additional AMT tax. Thus, A ends up paying AMT tax on $139, rather than on only the $100 of investment income that triggered the AMT.

A should not have to pay additional AMT tax on the $28 distribution (plus the $11 gross-up amount) needed by A to pay the AMT tax. To ensure that A pays only the original amount of AMT tax generated from the S corporation's investment income, the S corporation's distribution should be treated as a non-taxable distribution for AMT purposes.

Proposed Solution: An S corporation and its shareholders should maintain an AMT AAA and AMT stock bases, respectively, with AMT adjustments being taken into account at the corporate level.

AMT Stock Basis and AMT AAA. Congress intended that the AMT operate separate from, yet parallel to, the regular tax system. See Staff of the J. Comm. on Taxation, General Explanation of the Tax Reform Act of 1986 438 (Comm. Print 1987).

Consistent with this concept, an S corporation shareholder should maintain a separate AMT basis in S corporation stock and a separate AMT basis in debt owed from the S corporation to the shareholder. Cf. Prop. Treas. Reg. § 1.1502-55(g) (Dec. 30, 1992) (requiring members of an affiliated group of corporations filing a consolidated return to maintain separate AMT bases in the stock of other group members).

Furthermore, an S corporation should maintain a separate AMT AAA and a separate AMT subchapter C AEP account in order to carry out fully the separate, yet parallel, concept of the AMT.²

Corporate-Level Adjustments to AMT AAA for Investment Expenses. However, simply providing that an S corporation shall maintain an AMT AAA may not provide relief to A in the above hypothetical. Pursuant to Section 1363(b)(2), in determining an S corporation's taxable income, a deduction for investment expenses is not allowed; instead, these expenses are separately stated and taken into account by the shareholders of the S corporation under Section 1366(a)(1)(A). Thus, Section 1363(b)(2) appears to prohibit S corporations from treating their investment expenses as creating a Section 212 deduction at the corporate level.

As a result, the AMT provision disallowing Section 212 deductions (Section 56(b)(1)(A)) presumably would apply at the shareholder level rather than the corporate level. Because the AAA is a corporate-level account that generally adjusts only for corporate-level tax items, a shareholder-level AMT adjustment for S corporation investment expenses would not affect the S corporation's AMT AAA. See Section 1368(e)(1)(A).

In order to cause the S corporation's AMT AAA to reflect the AMT adjustment for S corporation investment expenses, the Proposed Solution expressly provides that the AMT adjustment for investment expenses (along with other adjustments and preferences) shall arise at the corporate level for purposes of adjusting the AMT AAA.

Clarifying Provisions. In order for an S corporation to adjust its AMT AAA for investment expenses, further clarifications are required.

An AMT adjustment with respect to investment expenses is generally provided for in Section 56(b)(1)(A). Section 56(b) applies to taxpayers other than corporations. Section 1363(b) provides that an S corporation shall compute its taxable income in the same manner as in the case of an individual, except that a deduction for investment expenses is not allowed.³

The Proposed Solution clarifies that, for purposes of adjusting AMT AAA (including adjustments for investment expenses), an S corporation shall be treated as an individual.

Section 1368(e)(1)(A) provides that the S corporation's AAA shall be generally adjusted in the same manner as stock basis is adjusted. Deductions that are permanently disallowed for AMT purposes (rather than temporarily disallowed),⁴ such as the deduction for investment expenses, should continue to reduce AMT stock basis.⁵

As a result, Section 1368(e)(1)(A) appears to require deductions that are permanently disallowed for AMT purposes to reduce the AMT AAA in the same manner as these deductions reduce AMT stock basis. However, for the $28 distribution in the above hypothetical to be treated as a non-taxable distribution for AMT purposes, AMT AAA must not be decreased by the amount of the investment expense deduction permanently disallowed for AMT purposes.⁶

Thus, the Proposed Solution severs the tie between AMT stock basis adjustments and AMT AAA adjustments to the extent that Section 1368(e)(1) would require an S corporation to reduce its AMT AAA for deductions that are permanently disallowed for AMT purposes.

Regulatory Solution: Issue a new Treasury regulation pursuant to Section 59(h).

This appears appropriate because Section 59(h) states, "The limitations of section[] ... 1366(d) (and such other provisions as may be specified in regulations) shall be applied for purposes of computing the alternative minimum taxable income of the taxpayer for the taxable year with the adjustments of sections 56, 57, and 58."

The Treasury Department has yet to issue Treasury regulations under Section 59.

Place the following language in a new Treas. Reg. § 1.59-1(h):

"(h) S corporation operations. For purposes of determining the alternative minimum taxable income of a taxpayer other than a corporation,

(1) a shareholder of an S corporation shall maintain the following:

(i) an alternative minimum tax basis in the stock of such S corporation, and

(ii) an alternative minimum tax basis in any indebtedness of such S corporation to the shareholder.

(2) an S corporation shall maintain the following:

(i) an alternative minimum tax accumulated adjustments account, and

(ii) an alternative minimum tax accumulated earnings and profits account.

(3) the alternative minimum tax accumulated adjustments account shall be adjusted in a manner similar to the manner in which the accumulated adjustments account for regular tax purposes shall be adjusted; provided, however, that notwithstanding section 1368(e)(1) and § 1.1368-1(e)(2)(ii), the adjustments described in sections 56, 58 and 59, and the items of tax preference described in section 57, shall adjust the alternative minimum tax accumulated adjustments account of such S corporation. For purposes of the preceding sentence, adjustments described in section 56 shall be computed by such S corporation in the same manner as in the case of an individual."

Application of Proposed Solution to Hypothetical: The Proposed Solution should produce the following results in the hypothetical set out above.

For purposes of determining the character of the original $28 distribution for AMT purposes, A would have a $100 AMT stock basis because the current stock basis adjustment rules provide that income and gain items, but not expense and loss items, adjust stock basis for purposes of determining the character of S corporation distributions.⁷

Moreover, the S corporation would have a $100 AMT AAA for purposes of determining the character of the $28 distribution for AMT purposes because the AMT AAA would reflect the $100 of S corporation investment income without reduction for the $100 of S corporation investment expense pursuant to Section 56(b)(1)(A).⁸

Thus, A would treat the original $28 distribution for AMT purposes as a tax-free return of basis (rather than as a dividend). See Sections 1368(b)(1), 1368(c)(1).⁹ The distribution would thus reduce A's AMT stock basis and the S corporation's AMT AAA by $28 (from $100 to $72).

After taking into account the $28 distribution, A would further reduce its AMT stock basis for the S corporation's permanently disallowed investment expenses. See Treas. Reg. §1.1367-1(f). Because stock basis cannot be negative, only $72 of the $100 of S corporation investment expense would reduce A's AMT stock basis. See Section 1367(a)(2).

The remaining $28 of S corporation investment expense would be suspended and carried to the next tax year for AMT purposes. See Sections 59(h), 1366(d).

Taking into account all events, A would be left with a $0 AMT stock basis and the S corporation would be left with a $72 AMT AAA.¹⁰