(b) Exception.-If an electing small business corporation is subject to the tax imposed by section 1378 for a taxable year, and

(1) The election under section 1372(a) which is in effect with respect to such corporation for such year has been in effect for the corporation's three immediately preceding taxable years, or

(2) An election under section 1372(a) has been in effect with respect to such corporation for each of its taxable years for which is has been in existence,

the amount of such tax for such year shall not exceed 25 percent of the excess of the net long-term capital gain over the net short-term capital loss attributable to property with a substituted basis (see section 1378(c) (3) and paragraph (b) of § 1.1378-2).

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

Example (1).-Corporation Q, an electing small business corporation, is subject to the tax imposed by section 1378 for its taxable year 1967, to be computed under paragraph (a) of this section. For 1967, Q has an excess of net long-term capital gain over net short-term capital loss in the amount of $73,000, and taxable income (computed under section 1373 (d), which includes capital gains and losses) of $100,000. The amount of tax computed under paragraph (a)(1) of this section is 25 percent of $48,000 ($73,000-$25.000), or $12,000. This is lower than the amount computed under paragraph (a) (2) of this section which is (assuming a $25,000 surtax exemption and no election under section 1562) 22 percent of $100,000 plus 26 percent of $75,000, or $41,500.

Example (2).-Assume that in example (1) the taxable income of Q for 1967 is $35,000. This results from an excess of deductions over income with respect to items which were not included in determining the excess of the net long-term capital gain over the net short-term capital loss. In such case, the amount of tax, computed under paragraph (a)(2) of this section, is 22 percent of $35,000 plus 26 percent of $10,000, or $10,300. This is lower than the amount computed under paragraph (a) (1) of this section, or $12,000.

Example (3).-Corporation R, an electing small business corporation, for its taxable year 1968 has an excess of net long-term capital gain over net short-term capital loss in the amount of $65,000 and has taxable income of $80,000. R's election under section 1372 (a) has been in effect for its 3 immediately preceding taxable years, but R, nevertheless, is subject to the tax imposed by section 1378 for 1968 since it has an excess of net long-term capital gain over net short-term capital loss (in the amount of $20,000) attributable to property with a substituted basis. The tax computed under paragraph (a) (1) of this section, $10,000 (25 percent of $40,000 ($65,000-$25,000)), is less than the tax computed under paragraph (a) (2) of this section, $31,900 (22 percent of $80,000 plus 26 percent of $55,000 (assuming a surtax exemption of $25,000 and no election under section 1562)). However, under the limitation provided in paragraph (b) of this section which is applicable in this factual situation, the tax imposed by section 1378 for 1968 may not exceed $5,000 (25 percent of $20,000, the excess of net long-term capital gain over net short-term capital loss attributable to property with a substituted basis).

PAR. 14. Paragraph (c) of § 1.1561-2 is amended to read as follows: § 1.1561-2 REDUCTION OF SURTAX EXEMPTION.

*

(c) Corporations affected.-The provisions of section 1561 may result in the reduction of the surtax exemption of any corporation which is a component member of a controlled group of corporations and which is subject to the tax imposed by section 11, or by any other provision of subtitle A of the Code if the tax under such other provisions is computed by reference to the amount of the surtax exemption provided by section 11. Such other provisions include, for example, sections 511(a) (1), 594, 802, 831, 852, 857, 882, 1201, and 1378.

PAR. 15. Paragraph (b)(4) of § 1.1562-1 is amended by revising subdivisions (iii) and (iv), and by adding a subdivision (v) at the end thereof. These amended provisions read as follows:

§1.1562-1 PRIVILEGE OF CONTROLLED GROUP TO ELECT MULTIPLE SURTAX EXEMPTIONS.

(iii) In the case of a regulated investment company, its "investment company taxable income" (as defined in section 852 (b) (2)).

(iv) In the case of a real estate investment trust, its "real estate investment trust taxable income" (as defined in section 857 (b) (2)), and

(v) In the case of an electing small business corporation, its "taxable income" (as defined in section 1373 (d)).

PAR. 16. Paragraph (b) (2) (ii) (c) of § 1.1563–1 is amended to read as follows:

§ 1.1563-1 DEFINITION OF CONTROLLED GROUP OF CORPORATIONS AND COMPONENT MEMBERS.

(b) Component members. *

(2) Excluded members. * (ii) * * *

(c) An electing small business corporation (as defined in section 1371(b)) not subject to the tax imposed by section 1378.

PAR. 17. Section 1.6012-2 is amended by redesignating paragraph (h) as paragraph (i) and by inserting a new paragraph (h) to read as follows:

§ 1.6012-2 CORPORATIONS REQUIRED TO MAKE RETURNS OF INCOME.

(h) Electing small business corporations.-An electing small business corporation, whether or not subject to the tax imposed by section 1378, shall make a return on Form 1120-S. See also section 6037 and the regulations thereunder.

(This Treasury decision is issued under the authority contained in section 7805 of the Internal Revenue Code of 1954 (68A Stat. 917; 26 U.S.C. 7805), and sections 1(d) and 3(b) of the Act of April 14, 1966 (Public Law 89-389, 80 Stat. 111, 115).)

Approved June 19, 1968.

STANLEY S. SURREY,

SHELDON S. COHEN, Commissioner of Internal Revenue.

Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on June 24, 1968, 8:47 a.m., and published in the issue of the Federal Register for June 25, 1968, 33 F.R. 9289)

SECTION 1372.-ELECTION BY SMALL BUSINESS

CORPORATION

26 CFR 1.1372: Statutory provisions; elec

tion by small business corporation.

Amendments to the regulations relating to the passive investment income of an electing small business corporation. See T.D. 6960, page 342.

The amount of debt on property sold by an electing small business corporation that is assumed by the purchaser is includible in the corporation's gross receipts under section 1372(e) (5) of the Code in the year of the sale.

26 CFR 1.1372-4: Termination of election.

Rev. Rul. 68-364

Advice has been requested whether a small business corporation can include in its gross receipts, under section 1372(e) (5) of the Internal Revenue Code of 1954, the amount of its debt that was assumed by the purchaser who bought its encumbered property.

X, an electing small business corporation under Subchapter S of chapter 1 of the Code, executed an agreement to sell certain operating assets for a total price of 2,000x dollars as follows:

1,000r dollars-assumption by the buyer of the seller's total indebtedness on the property

2,000 dollars-total price

In the year of the sale the buyer made no payment on the principal of the note, but paid X corporation 75 dollars of interest on the promissory note. In addition, the corporation received 175 dollars of interest on other investments. The 250x dollars of interest is "passive investment income" as defined in section 1372 (e) (5) (C) of the Code. Under the provisions of section 1372 (e) (5) (A) of the Code, X corporation's election as a small business corporation would terminate if its passive income amounted to more than 20 percent of its gross receipts for the taxable year. Therefore, the question arose whether I corporation could include in its gross receipts the amount of the debt that was assumed by the purchaser who bought the encumbered property.

The amount received or accrued from the sale or exchange of property is not confined to cash items, but includes other items that enter into the amount realized by the taxpayer. Thus, the amount received or accrued from the sale or exchange of property includes any property in kind received by the seller, and any liabilities of the seller, including encumbrances on the property sold, taken over by another party. See Beulah B. Crane v. Commissioner, 331 U.S. 1 (1947), Ct. D. 1684, C.B. 1947-1, 97. This is true regardless of the taxpayer's method of accounting for the sale.

Because the seller is relieved of the burden of the mortgage in the year of the sale, the amount of the assumed liability is constructively received in that year. Since this is the only time the assumed liability is accounted for, it is also the time for it to be included in the seller's gross receipts under section 1372(e) (5) of the Code.

Therefore, the amount of X corporation's debt assumed by the purchaser who bought its encumbered property is includible in the gross receipts of X corporation under section 1372 (e) (5) of the Code in the year of the sale.

SECTION 1373.-CORPORATION UNDISTRIBUTED TAX

ABLE INCOME TAXED TO SHAREHOLDERS

26 CFR 1.1373: Statutory provisions; cor

poration undistributed taxable income

taxed to shareholders.

Amendments to the regulations relating to the computation of the undistributed taxable income included in the gross income of shareholders. See T.D. 6960, page 342.

SECTION 1375.-SPECIAL RULES APPLICABLE TO DISTRIBUTIONS OF ELECTING SMALL BUSINESS CORPORATIONS

26 CFR 1.1375: Statutory provisions; special rules applicable to distributions of elec

ting small business corporations.

Amendments to the regulations relating to the treatment of longterm capital gains and certain distributions by an electing small business corporation. See T.D. 6960, page 342.

A shareholder-creditor of a small business corporation derives ordinary income from the repayment of a loan made on open account to the extent that the repayments exceed his basis in the loan.

SECTION 1376.-ADJUSTMENTS TO BASIS OF STOCK OF, AND INDEBTEDNESS OWING, SHAREHOLDERS

26 CFR 1.1376-1: Adjustment to basis of stock of, and indebtedness to, shareholders; increase in basis of stock.

Rev. Rul. 68-537

An electing small business corporation, as defined in section 1371 of the Internal Revenue Code of 1954, repaid to one of its shareholders a loan made on open account. The shareholder's basis in the loan was reduced by the amount by which his share of the corporation net operating loss exceeded his basis in the corporation's stock.

Held, the installments received by the shareholder in retirement of the loan must be allocated in part to a return of his basis in the loan and in part to income, but the income is ordinary income and not income from the exchange of a capital asset. See Joe M. Smith and Florence P. Smith et al v. Commissioner, 48 T.C. 872 (1967).

The situation here involved is distinguishable from that in Revenue Ruling 64-162, C.B. 1964–1 (Part 1), 304, since in that Revenue Ruling the corporation had issued its shareholder a note as an evidence of the indebtedness and such note was a capital asset in the hands of the shareholder.

SECTION 1378.-TAX IMPOSED ON CERTAIN CAPITAL GAINS

26 CFR 1.1378: Statutory provisions; tax imposed on certain capital gains.

Regulations relating to the tax imposed at the corporate level on certain capital gains of an electing small business corporation. See T.D. 6960, page 342.

Deductibility of unclaimed nonpatronage allocations paid over to a State pursuant to an escheat law. See Rev. Rul. 68-423, below.

Unclaimed allocations of nonpatronage income paid to a State by an exempt farmers' cooperative pursuant to the State's escheat law are deductible by the cooperative under sections 1382 (c) and (d) of the Code; such amounts must be reported on information returns.

SECTION 1382.-TAXABLE INCOME OF COOPERATIVES

26 CFR 1.1382-3: Taxable income of cooperatives; special deductions for exempt farmers' cooperatives.

(Also Sections 1381, 6044; 1.1381-1, 1.6044-2.)

Rev. Rul. 68-423

Advice has been requested whether amounts representing unclaimed allocations of nonpatronage income paid over to a State by an "exempt" cooperative pursuant to the escheat law of the State are deductible by the cooperative for Federal income tax purposes, under the circumstances described below.

A cooperative of the type described in section 1381 (a) (1) of the Internal Revenue Code of 1954 (an "exempt" farmers' cooperative) had for a period of three years ceased all normal operations and was in the process of converting its various assets into cash. In its final taxable year the cooperative realized substantial interest income on the proceeds from the sale of its assets, which had been deposited in commercial banks. For Federal income tax purposes, such interest income was included in the gross income of the cooperative for its final

334-533-6926