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1997 Department of the TreasuryInternal Revenue ServiceInstructions for Form 1120SU.S. Income Tax Return for an S CorporationSection references are to the Internal Revenue Code unless otherwise noted.

Paperwork Reduction Act Notice. We ask for the information on this form to carry out theInternal Revenue laws of the United States. You are required to give us the information. We needit to ensure that you are complying with these laws and to allow us to figure and collect the rightamount of tax.

You are not required to provide the information requested on a form that is subject to thePaperwork Reduction Act unless the form displays a valid OMB control number. Books or recordsrelating to a form or its instructions must be retained as long as their contents may becomematerial in the administration of any Internal Revenue law. Generally, tax returns and returninformation are confidential, as required by section 6103.

The time needed to complete and file this form and related schedules will vary depending onindividual circumstances. The estimated average times are:

If you have comments concerning the accuracy of these time estimates or suggestions formaking these forms simpler, we would be happy to hear from you. You can write to the Tax FormsCommittee, Western Area Distribution Center, Rancho Cordova, CA 95743-0001. DO NOT sendthe tax form to this address. Instead, see Where To File on page 3.

General Instructions

Changes To Note

The Small Business Job Protection Act of 1996made the following changes that affect Scorporations. Unless otherwise noted, thechanges are effective for tax years beginningafter 1996:q The maximum number of permittedshareholders has been increased to 75.q A new type of trust, an "electing smallbusiness trust," is permitted to be a

shareholder. An electing small business trustis an eligible trust that has made an election inaccordance with Notice 97-12, 1997-3 I.R.B.11, and that does not have as a beneficiary anyperson other than an individual, an estate, ora charity that holds a contingent remainderinterest.q A financial institution that does not use thereserve method of accounting for bad debtsunder section 585 is eligible to be an Scorporation.q The period during which a testamentary trustmay remain a shareholder following the deathof the deemed owner is extended to 2 years.q There is no longer any restriction on thepercentage of another corporation's stock thatan S corporation may hold. In addition, an S

corporation may make an election to treat theassets, liabilities, income, deductions, andcredits of a wholly-owned subsidiary as thoseof the parent S corporation. For details onmaking the election, see Notice 97-4, 1997-2I.R.B. 24.q For an election to be an S corporation for taxyears beginning after 1982, the IRS has beengiven the authority to:

1. Allow an S corporation that hasinadvertently made an invalid election to betreated as an S corporation for a specifiedperiod if the corporation takes the stepsneeded to perfect the election. To obtain relieffor an invalid election, the corporation generallymust request a private letter ruling and pay auser fee.

2. Treat late elections as timely made if thecorporation demonstrates reasonable cause forbeing late. To obtain relief for a late election,the corporation generally must request aprivate letter ruling and pay a user fee. Incertain cases, these requirements do not apply.For details, see Rev. Proc. 97-40, 1997-33I.R.B. 50, and Rev. Proc. 97-48, 1997-43 I.R.B.19.q The election to close the corporation's bookswhen a shareholder terminates his or herinterest in the S corporation is made by thecorporation and the affected shareholdersrather than all shareholders.

Contents PageCodes for Principal Business Activity . 23

Form RecordkeepingLearning about the

law or the formPreparing the

form

Copying,assembling, andsending the form

to the IRS

1120S 63 hr., 8 min. 20 hr., 37 min. 36 hr., 31 min. 4 hr., 1 min.

Sch. D (1120S) 10 hr., 31 min. 4 hr., 20 min. 9 hr., 20 min. 1 hr., 20 min.Sch. K-1 (1120S) 15 hr., 4 min. 10 hr., 19 min. 14 hr., 44 min. 1 hr., 4 min.

Contents PageContents Page

General Instructions for Schedules Kand K-1 . . . . . . . . . . . . . . 14

Changes To Note . . . . . . . . . . . 1

Unresolved Tax Problems . . . . . . . 2Purpose of Schedules . . . . . . . . 14

How To Make a Contribution To Reduce thePublic Debt . . . . . . . . . . . . . 2 Substitute Forms . . . . . . . . . . 14

Shareholder's Pro Rata Share Items . 14How To Get Forms and Publications . . 2

Specific Instructions (Schedule K Only) 15General Instructions . . . . . . . . . 2

Specific Instructions (Schedule K-1Only) . . . . . . . . . . . . . . . 15

Purpose of Form . . . . . . . . . . 2

Who Must File . . . . . . . . . . . 2General Information . . . . . . . . . 15

Termination of Election . . . . . . . 2Special Reporting Requirements for

Corporations With Multiple Activities 15When To File . . . . . . . . . . . . 2

Period Covered . . . . . . . . . . . 3 Special Reporting Requirements forAt-Risk Activities . . . . . . . . . 15Where To File . . . . . . . . . . . 3

Who Must Sign . . . . . . . . . . . 3 Specific Items . . . . . . . . . . . . 15Accounting Methods . . . . . . . . . 3 Specific Instructions (Schedules K and

K-1, Except as Noted) . . . . . . . 15Accounting Periods . . . . . . . . . 3

Rounding Off to Whole Dollars . . . . 4 Income (Loss) . . . . . . . . . . . 15

Recordkeeping . . . . . . . . . . . 4 Deductions . . . . . . . . . . . . . 16

Depository Method of Tax Payment . . 4 Investment Interest . . . . . . . . . 17

Estimated Tax . . . . . . . . . . . 4 Credits . . . . . . . . . . . . . . . 17

Interest and Penalties . . . . . . . . 4 Adjustments and Tax Preference Items 18

Other Forms and Statements That May BeRequired . . . . . . . . . . . . . 5

Foreign Taxes . . . . . . . . . . . 19Other . . . . . . . . . . . . . . . 19

Attachments . . . . . . . . . . . . 5 Supplemental Information . . . . . . 20Amended Return . . . . . . . . . . 6 Specific Instructions . . . . . . . . . 21Passive Activity Limitations . . . . . 6 Schedule LBalance Sheets per Books 21

Specific Instructions . . . . . . . . . 9 Schedule M-1Reconciliation of Income(Loss) per Books With Income (Loss)per Return . . . . . . . . . . . . 21

General Information . . . . . . . . . 9

Income . . . . . . . . . . . . . . . 9Schedule M-2Analysis of Accumulated

Adjustments Account, OtherAdjustments Account, andShareholders' Undistributed TaxableIncome Previously Taxed . . . . . 21

Deductions . . . . . . . . . . . . . 10

Tax and Payments . . . . . . . . . 12

Schedule ACost of Goods Sold . . 13

Schedule BOther Information . . . 14

Cat. No. 11515K

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q The consolidated audit procedures at thecorporate level that applied to certaincorporations, including those with more than 5shareholders, have been repealed. Instead, Scorporation items will be determined inseparate proceedings with the individualshareholders.q Any net negative adjustment for the tax year(as defined in section 1368(e)(1)(C)(ii)) isdisregarded when figuring the accumulatedadjustments account for the purpose ofdetermining the taxability of distributions forthat tax year.q For its first tax year beginning after 1996, anS corporation's accumulated earnings andprofits (E&P) is reduced (as of the first day ofthat year) by the E&P accumulated from anytax year beginning before 1983 when thecorporation was a subchapter S corporation.Thus, an S corporation's E&P after 1996 issolely attributable to tax years when thecorporation did not have an S election in effect.q For purposes of the 5-year waiting periodthat generally applies to an election to be anS corporation after a prior termination, anytermination in a tax year beginning before 1997is not taken into account.

The Taxpayer Relief Act of 1997 (the Act)made the following changes that affect Scorporations:q Employers that pay wages to long-termfamily assistance recipients may qualify for thewelfare-to-work credit. This new credit is basedon wages paid to qualified individuals whobegin work after December 31, 1997, and isfigured on Form 8861, Welfare-to-Work Credit.q The penalty for failure to make electronicdeposits of depository taxes using theElectronic Federal Tax Payment System(EFTPS), has been temporarily waived for filerswho were first required to use EFTPS on orafter July 1, 1997. For more information, seeElectronic Deposit Requirement on page 4.q For tax years ending after August 5, 1997,commodities dealers and traders ofcommodities and securities may make an

election to use the mark-to-market accountingmethod. For more information, see Act section1001.q The Act imposed additional limitations on thededuction of premiums and interest on debtwith respect to life insurance, annuity, orendowment contracts. The Act also reducesinterest deductions that are allocable, underproration rules described in new section 264(f),to the unborrowed policy cash values of certainlife insurance, endowment, or annuity contractsissued or deemed issued after June 8, 1997.For details, see section 264.

Unresolved Tax Problems

The Problem Resolution Program is fortaxpayers that have been unable to resolve

their problems with the IRS. If the corporationhas a tax problem it cannot clear up throughnormal channels, write to the corporation'slocal IRS District Director or call thecorporation's local IRS office and ask forProblem Resolution assistance. Persons whohave access to TTY/TDD equipment may call1-800-829-4059 to ask for help from ProblemResolution. This office cannot change the taxlaw or technical decisions. But it can help thecorporation clear up problems that resultedfrom previous contacts.

How To Make a Contribution ToReduce the Public Debt

To make a contribution to reduce the publicdebt, send a check made payable to "Bureauof the Public Debt" to Bureau of the PublicDebt, Department G, Washington, DC20239-0601. Or, enclose a check with Form1120S. Contributions to reduce the public debtare deductible, subject to the rules andlimitations for charitable contributions.

How To Get Forms andPublications

Personal Computer

Visit the IRS's Internet Web Site atwww.irs.ustreas.gov to get:q Forms and instructionsq Publicationsq IRS press releases and fact sheets.

You can also reach us using:q Telnet at iris.irs.ustreas.govq File Transfer Protocol at

ftp.irs.ustreas.govq Direct Dial (by modem). Dial direct to theInternal Revenue Information Services (IRIS)by calling 703-321-8020 using your modem.IRIS is an on-line information service onFedWorld.

CD-ROM

A CD-ROM containing over 2,000 tax products(including many prior year forms) can bepurchased from the Government Printing Office(GPO). To order the CD-ROM, call theSuperintendent of Documents at2025121800 or go through GPO's InternetWeb Site (www.access.gpo.gov/su_docs).

By Phone and in Person

To order forms and publications, call1-800-TAX-FORM (1-800-829-3676) between7:30 a.m. and 5:30 p.m. on weekdays. You can

also get most forms and publications at yourlocal IRS office.

Purpose of Form

Form 1120S is used to report the income,deductions, gains, losses, etc., of a domesticcorporation that has elected to be an Scorporation by filing Form 2553, Election by aSmall Business Corporation, and whoseelection is in effect for the tax year.

Who Must File

A corporation must file Form 1120S if (a) itelected to be an S corporation by filing Form2553, (b) the IRS accepted the election, and(c) the election remains in effect. Do not file

Form 1120S for any tax year before the yearthe election takes effect.

Termination of Election

Once the election is made, it stays in effectuntil it is terminated. If the election isterminated in a tax year beginning after 1996,the corporation (or a successor corporation)can make another election on Form 2553 onlywith IRS consent for any tax year before the5th tax year after the first tax year in which thetermination took effect. See Regulationssection 1.1362-5 for more details.

An election terminates automatically in anyof the following cases:

1. The corporation is no longer a smallbusiness corporation as defined in section1361(b). The termination of an election in thismanner is effective as of the day on which thecorporation no longer meets the definition of asmall business corporation. If the electionterminates for this reason, attach to Form1120S for the final year of the S corporation astatement notifying the IRS of the terminationand the date it occurred.

2. The corporation, for each of three

consecutive tax years, (a) has accumulatedearnings and profits and (b) derives more than25% of its gross receipts from passiveinvestment income as defined in section1362(d)(3)(C). The election terminates on thefirst day of the first tax year beginning after thethird consecutive tax year. The corporationmust pay a tax for each year it has excess netpassive income. See the instructions for line22a for details on how to figure the tax.

3. The election is revoked. An election maybe revoked only with the consent ofshareholders who, at the time the revocation ismade, hold more than 50% of the number ofissued and outstanding shares of stock(including non-voting stock). The revocationmay specify an effective revocation date that is

on or after the day the revocation is filed. If nodate is specified, the revocation is effective atthe start of a tax year if the revocation is madeon or before the 15th day of the 3rd month ofthat tax year. If no date is specified and therevocation is made after the 15th day of the 3rdmonth of the tax year, the revocation iseffective at the start of the next tax year.

To revoke the election, the corporation mustfile a statement with the service center whereit filed its election to be an S corporation. In thestatement, the corporation must notify the IRSthat it is revoking its election to be an Scorporation. The statement must be signed byeach shareholder who consents to therevocation and contain the information requiredby Regulations section 1.1362-6(a)(3). A

revocation may be rescinded before therevocation takes effect. See Regulationssection 1.1362-6(a)(4) for details.

For rules on allocating income anddeductions between an S short year and a Cshort year and other special rules that applywhen an election is terminated, see section1362(e) and Regulations section 1.1362-3.

If an election was terminated under 1 or 2above, and the corporation believes thetermination was inadvertent, the corporationmay request permission from the IRS tocontinue to be treated as an S corporation. SeeRegulations section 1.1362-4 for the specificrequirements that must be met to qualify forinadvertent termination relief.

When To FileIn general, file Form 1120S by the 15th day ofthe 3rd month following the date thecorporation's tax year ended as shown at thetop of Form 1120S. For calendar yearcorporations, the due date is March 16, 1998.If the due date falls on a Saturday, Sunday, orlegal holiday, file on the next business day. Abusiness day is any day that is not a Saturday,Sunday, or legal holiday.

If the S election was terminated during thetax year, file Form 1120S for the S short yearby the due date (including extensions) of theC short year return.

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Private Delivery Services

You can use certain private delivery servicesdesignated by the IRS to meet the timely filingas timely filing/paying rule for tax returns andpayments. The IRS publishes a list ofdesignated private delivery services inSeptember of each year. The list published inSeptember 1997 includes only the following:q Airborne Express (Airborne): Overnight AirExpress Service, Next Afternoon Service,Second Day Service.q DHL Worldwide Express (DHL): DHL "Same

Day" Service, DHL USA Overnight.q Federal Express (FedEx): FedEx PriorityOvernight, FedEx Standard Overnight, FedEx2Day.q United Parcel Service (UPS): UPS Next DayAir, UPS Next Day Air Saver, UPS 2nd DayAir, UPS 2nd Day Air A.M.

The private delivery service can tell you howto get written proof of the mailing date.

Extension

Use Form 7004, Application for AutomaticExtension of Time To File Corporation IncomeTax Return, to request an automatic 6-monthextension of time to file Form 1120S.

Period CoveredFile the 1997 return for calendar year 1997 andfiscal years beginning in 1997 and ending in1998. If the return is for a fiscal year or a shorttax year, fill in the tax year space at the top ofthe form.

Note: The 1997 Form 1120S may also beused if(a)the corporation has a tax year ofless than 12 months that begins and ends in1998 and(b)the 1998 Form 1120S is notavailable by the time the corporation is requiredto file its return. However, the corporation mustshow its 1998 tax year on the 1997 Form1120S and incorporate any tax law changesthat are effective for tax years beginning afterDecember 31, 1997.

Where To FileFile your return at the applicable IRS addresslisted below.

Who Must Sign

The return must be signed and dated by thepresident, vice president, treasurer, assistanttreasurer, chief accounting officer, or any othercorporate officer (such as tax officer)authorized to sign. A receiver, trustee, orassignee must sign and date any return he orshe is required to file on behalf of acorporation.

If a corporate officer filled in Form 1120S,the Paid Preparer's space under Signature of

officer should remain blank. If someoneprepares Form 1120S and does not charge thecorporation, that person should not sign thereturn. Certain others who prepare Form 1120Sshould not sign. For example, a regular,full-time employee of the corporation such asa clerk, secretary, etc., should not sign.

Generally, anyone paid to prepare Form1120S must sign the return and fill in the otherblanks in the Paid Preparer's Use Only area ofthe return.

The preparer required to sign the returnMUST complete the required preparerinformation and:q Sign it, by hand, in the space provided for thepreparer's signature. (Signature stamps orlabels are not acceptable.)q Give a copy of Form 1120S to the taxpayerin addition to the copy filed with the IRS.

Accounting Methods

Figure ordinary income using the method ofaccounting regularly used in keeping thecorporation's books and records. Generally,permissible methods include:q Cash,q Accrual, orq Any other method permitted by the InternalRevenue Code.

In all cases, the method adopted mustclearly reflect income.

Generally, an S corporation may not use the

cash method of accounting if the corporation isa tax shelter (as defined in section 448(d)(3)).See section 448 for details.

Under the accrual method, an amount isincludible in income when:q All the events have occurred that fix the rightto receive the income, andq The amount can be determined withreasonable accuracy.

See Regulations section 1.451-1(a) fordetails.

Generally, an accrual basis taxpayer candeduct accrued expenses in the tax year inwhich:

q All events that determine liability haveoccurred,q The amount of the liability can be figured withreasonable accuracy, andq Economic performance takes place withrespect to the expense. There are exceptionsfor certain items, including recurring expenses.See section 461(h) and the related regulationsfor the rules for determining when economicperformance takes place.

Except for certain home constructioncontracts and other real property smallconstruction contracts, long-term contractsmust generally be accounted for using thepercentage of completion method described insection 460.

Mark-to-Market Accounting Method forDealers in Securities

Dealers in securities must use themark-to-market accounting method describedin section 475. Under this method, any securitythat is inventory to the dealer must be includedin inventory at its fair market value. Anysecurity that is not inventory and that is heldat the close of the tax year is treated as soldat its fair market value on the last business dayof the tax year, and any gain or loss must betaken into account in determining grossincome. The gain or loss taken into account isgenerally treated as ordinary gain or loss. Fordetails, including exceptions, see section 475and the related regulations.

Note: For tax years ending after August 5,1997, dealers in commodities, and traders insecurities and commodities, may make anelection to use the mark-to-market accountingmethod. See sections 475(e) and (f) for details.

Change in Accounting Method

Generally, the corporation may change itsmethod of accounting used to report taxableincome (for income as a whole or for anymaterial item) only by getting consent on Form3115, Application for Change in AccountingMethod. For more information, see Pub. 538,

Accounting Periods and Methods.

Accounting Periods

Generally, an S corporation may not change itsaccounting period to a tax year that is not apermitted year. A permitted year is a calendaryear or any other accounting period for whichthe corporation can establish to the satisfactionof the IRS that there is a business purpose forthe tax year.

To change an accounting period, seeRegulations section 1.442-1 and Form 1128,Application To Adopt, Change, or Retain a TaxYear. Also see Pub. 538.

Election of a Tax Year Other Than aRequired Year

Under the provisions of section 444, an Scorporation may elect to have a tax year otherthan a permitted year, but only if the deferralperiod of the tax year is not longer than theshorter of 3 months or the deferral period of thetax year being changed. This election is madeby filing Form 8716, Election To Have a TaxYear Other Than a Required Tax Year.

An S corporation may not make or continuean election under section 444 if it is a memberof a tiered structure, other than a tieredstructure that consists entirely of partnershipsand S corporations that have the same taxyear. For the S corporation to have a section

Alaska, Arizona, California (countiesof Alpine, Amador, Butte, Calaveras,Colusa, Contra Costa, Del Norte, ElDorado, Glenn, Humboldt, Lake,Lassen, Marin, Mendocino, Modoc,Napa, Nevada, Placer, Plumas,Sacramento, San Joaquin, Shasta,Sierra, Siskiyou, Solano, Sonoma,Sutter, Tehama, Trinity, Yolo, andYuba), Colorado, Idaho, Montana,Nebraska, Nevada, North Dakota,Oregon, South Dakota, Utah,Washington, Wyoming

Ogden, UT84201-0013

California (all other counties),Hawaii

Fresno, CA93888-0013

Delaware, District of Columbia,Maryland, Pennsylvania, Virginia

Philadelphia, PA19255-0013

If the corporation'sprincipal business,office, or agency is

located in

Use the followingInternal RevenueService Center

address

New Jersey, New York (New YorkCity and counties of Nassau,Rockland, Suffolk, and Westchester)

Holtsville, NY00501-0013

New York (all other counties),Connecticut, Maine, Massachusetts,New Hampshire, Rhode Island,Vermont

Andover, MA05501-0013

Florida, Georgia, South CarolinaAtlanta, GA39901-0013

Indiana, Kentucky, Michigan, Ohio,West Virginia

Cincinnati, OH45999-0013

Kansas, New Mexico, Oklahoma,Texas

Austin, TX73301-0013

Illinois, Iowa, Minnesota, Missouri,Wisconsin

Kansas City, MO64999-0013

Alabama, Arkansas, Louisiana,Mississippi, North Carolina,Tennessee

Memphis, TN37501-0013

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444 election in effect, it must make thepayments required by section 7519 and fileForm 8752, Required Payment or RefundUnder Section 7519.

A section 444 election ends if an Scorporation changes its accounting period to acalendar year or some other permitted year; itis penalized for willfully failing to comply withthe requirements of section 7519; or its Selection is terminated (unless it immediatelybecomes a personal service corporation). If thetermination results in a short tax year, type orlegibly print at the top of the first page of Form

1120S for the short tax year, SECTION 444ELECTION TERMINATED.

Rounding Off to Whole Dollars

You may round off cents to whole dollars onyour return and accompanying schedules. Todo so, drop amounts under 50 cents andincrease amounts from 50 to 99 cents to thenext higher dollar.

Recordkeeping

The corporation's records must be kept as longas they may be needed for the administrationof any provision of the Internal Revenue Code.Usually, records that support an item ofincome, deduction, or credit on thecorporation's return must be kept for 3 yearsfrom the date each shareholder's return is dueor is filed, whichever is later. Keep records thatverify the corporation's basis in property for aslong as they are needed to figure the basis ofthe original or replacement property.

The corporation should also keep copies ofany returns it has filed. They help in preparingfuture returns and in making computationswhen filing an amended return.

Depository Method of TaxPayment

The corporation must pay the tax due in full nolater than the 15th day of the 3rd month afterthe end of the tax year. Some corporations(described below) are required to electronicallydeposit all depository taxes, includingcorporation income tax payments.

Electronic Deposit Requirement

The corporation must make electronic depositsfor all depository tax liabilities that occur after1997 if:q It was required to electronically deposit taxesin prior years,q It deposited more than $50,000 in socialsecurity, Medicare, and withheld income taxesin 1996, orq It did not deposit social security, Medicare,or withheld income taxes in 1995 or 1996, butdeposited more than $50,000 in other taxes

under section 6302 (such as corporate incometaxes) in either year.

For details, see Regulations section31.6302-1(h).

The Electronic Federal Tax Payment System(EFTPS) must be used to make electronicdeposits. If the corporation is required to makeelectronic deposits and fails to do so, it maybe subject to a 10% penalty.

Note: A penalty will not be imposed prior toJuly 1, 1998, if the corporation was firstrequired to use EFTPS on or after July 1, 1997.

Corporations that are not required to makeelectronic deposits may voluntarily participatein EFTPS. To enroll in EFTPS, call1-800-945-8400 or 1-800-555-4477. Forgeneral information on EFTPS, call1-800-829-1040.

Deposits With Form 8109

If the corporation does not use EFTPS, depositcorporation income tax payments (andestimated tax payments) with Form 8109,Federal Tax Deposit Coupon. Do not submitdeposits directly to an IRS office; otherwise, the

corporation may have to pay a penalty. Mail ordeliver the completed Form 8109 with thepayment to a qualified depositary for Federaltaxes or to the Federal Reserve bank (FRB)servicing your geographic area. Make yourchecks or money orders payable to thatdepositary or FRB.

To help ensure proper crediting, write thecorporation's employer identification number,the tax period to which the deposit applies, andForm 1120S on your check or money order.Be sure to darken the 1120 box on thecoupon. These records of deposit will be sentto the IRS.

For more information on deposits, see theinstructions in the coupon booklet (Form 8109)and Pub. 583, Starting a Business and

Keeping Records.

Estimated Tax

Generally, the corporation must makeestimated tax payments for the following taxesif the total of these taxes is $500 or more: (a)the tax on certain capital gains, (b) the tax onbuilt-in gains, (c) the excess net passiveincome tax, and (d) the investment creditrecapture tax.

The amount of estimated tax required to bepaid annually is the smaller of (a) the total ofthe above taxes shown on the return for the taxyear (or if no return is filed, the total of thesetaxes for the year); or (b) the sum of (i) theinvestment credit recapture tax and the built-in

gains tax (or the tax on certain capital gains)shown on the return for the tax year (or if noreturn is filed, the total of these taxes for theyear), and (ii) any excess net passive incometax shown on the corporation's return for thepreceding tax year. If the preceding tax yearwas less than 12 months, the estimated taxmust be determined under (a).

The estimated tax is generally payable infour equal installments. However, thecorporation may be able to lower the amountof one or more installments by using theannualized income installment method oradjusted seasonal installment method undersection 6655(e).

For a calendar year corporation, thepayments are due for 1998 by April 15, June

15, September 15, and December 15. For afiscal year corporation, they are due by the15th day of the 4th, 6th, 9th, and 12th monthsof the fiscal year.

The corporation must make the paymentsusing the depository method described above.

Interest and Penalties

Interest

Interest is charged on taxes not paid by the duedate, even if an extension of time to file is

granted. Interest is also charged from the duedate (including extensions) to the date ofpayment on the failure to file penalty, theaccuracy-related penalty, and the fraudpenalty. The interest charge is figured at a ratedetermined under section 6621.

Late Filing of Return

A corporation that does not file its tax returnby the due date, including extensions, mayhave to pay a penalty of 5% a month, or partof a month, up to a maximum of 25%, for eachmonth the return is not filed. The penalty is

imposed on the net amount due. The minimumpenalty for filing a return more than 60 dayslate is the smaller of the tax due or $100. Thepenalty will not be imposed if the corporationcan show that the failure to file on time was dueto reasonable cause. If the failure is due toreasonable cause, attach an explanation to thereturn.

Late Payment of Tax

A corporation that does not pay the tax whendue generally may have to pay a penalty of 1/2of 1% a month or part of a month, up to amaximum of 25%, for each month the tax is notpaid. The penalty is imposed on the net amountdue.

The penalty will not be imposed if the

corporation can show that failure to pay on timewas due to reasonable cause.

Failure To Furnish Information Timely

Section 6037(b) requires an S corporation tofurnish to each shareholder a copy of theinformation shown on Schedule K-1 (Form1120S) that is attached to Form 1120S.Provide Schedule K-1 to each shareholder onor before the day on which the corporation filesForm 1120S.

For each failure to furnish Schedule K-1 toa shareholder when due and each failure toinclude on Schedule K-1 all the informationrequired to be shown (or the inclusion ofincorrect information), a $50 penalty may beimposed with regard to each Schedule K-1 for

which a failure occurs. If the requirement toreport correct information is intentionallydisregarded, each $50 penalty is increased to$100 or, if greater, 10% of the aggregateamount of items required to be reported. Seesections 6722 and 6724 for more information.

The penalty will not be imposed if thecorporation can show that not furnishinginformation timely was due to reasonablecause and not due to willful neglect.

Trust Fund Recovery Penalty

This penalty may apply if certain excise,income, social security, and Medicare taxesthat must be collected or withheld are notcollected or withheld, or these taxes are notpaid to the IRS. These taxes are generallyreported on Forms 720, 941, 943, or 945. Thetrust fund recovery penalty may be imposed onall persons who are determined by the IRS tohave been responsible for collecting,accounting for, and paying over these taxes,and who acted willfully in not doing so. Thepenalty is equal to the unpaid trust fund tax.See the instructions for Form 720, Pub. 15(Circular E), Employer's Tax Guide, or Pub.51 (Circular A), Agricultural Employer's TaxGuide, for more details, including the definitionof responsible persons.

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Other Forms and StatementsThat May Be Required

q Forms W-2 and W-3, Wage and TaxStatement; and Transmittal of Wage and TaxStatements.q Form 720, Quarterly Federal Excise TaxReturn. Use Form 720 to report environmentalexcise taxes, communications and airtransportation taxes, fuel taxes, luxury tax onpassenger vehicles, manufacturers' taxes, shippassenger tax, and certain other excise taxes.

Caution: SeeTrust Fund Recovery Penaltyon page 4.q Form 940 or Form 940-EZ, Employer'sAnnual Federal Unemployment (FUTA) TaxReturn. The corporation may be liable for FUTAtax and may have to file Form 940 or 940-EZif it paid wages of $1,500 or more in anycalendar quarter during the calendar year (orthe preceding calendar year) or one or moreemployees worked for the corporation for somepart of a day in any 20 different weeks duringthe calendar year (or the preceding calendaryear). A corporate officer who performssubstantial services is considered anemployee. Except as provided in section3306(a), reasonable compensation for theseservices is subject to FUTA tax, no matter what

the corporation calls the payments.q Form 941, Employer's Quarterly Federal TaxReturn. Employers must file this form quarterlyto report income tax withheld on wages andemployer and employee social security andMedicare taxes. A corporate officer whoperforms substantial services is considered anemployee. Except as provided in sections3121(a) and 3401(a), reasonablecompensation for these services is subject toemployer and employee social security andMedicare taxes and income tax withholding, nomatter what the corporation calls the payments.Agricultural employers must file Form 943,Employer's Annual Tax Return for AgriculturalEmployees, instead of Form 941, to reportincome tax withheld and employer andemployee social security and Medicare taxeson farmworkers.

Caution: SeeTrust Fund Recovery Penaltyon page 4.q Form 945, Annual Return of WithheldFederal Income Tax. Use this form to reportincome tax withheld from nonpayroll payments,including pensions, annuities, IRAs, gamblingwinnings, and backup withholding.

Caution: SeeTrust Fund Recovery Penaltyon page 4.q Form 966, Corporate Dissolution orLiquidation.q Forms 1042 and 1042-S, AnnualWithholding Tax Return for U.S. SourceIncome of Foreign Persons; and ForeignPerson's U.S. Source Income Subject to

Withholding. Use these forms to report andtransmit withheld tax on payments made tononresident alien individuals, foreignpartnerships, or foreign corporations to theextent such payments constitute gross incomefrom sources within the United States (seesections 861 through 865). For moreinformation, see sections 1441 and 1442, andPub. 515, Withholding of Tax on NonresidentAliens and Foreign Corporations.q Form 1096, Annual Summary andTransmittal of U.S. Information Returns.q Form 1098, Mortgage Interest Statement.Use this form to report the receipt from any

individual of $600 or more of mortgage interestand points in the course of the corporation'strade or business.q Forms 1099-A, B, C, DIV, INT, LTC, MISC,MSA, OID, PATR, R, and S. You may have tofile these information returns to reportacquisitions or abandonments of securedproperty; proceeds from broker and barterexchange transactions; cancellation of debt;certain dividends and distributions; interestpayments; payments of long-term care andaccelerated death benefits; miscellaneousincome payments; distributions from a medical

savings account; original issue discount;distributions from cooperatives to their patrons;distributions from pensions, annuities,retirement or profit-sharing plans, IRAs,insurance contracts, etc.; and proceeds fromreal estate transactions. Also use certain ofthese returns to report amounts that werereceived as a nominee on behalf of anotherperson.

Use Form 1099-DIV to report actualdividends paid by the corporation. Onlydistributions from accumulated earnings andprofits are classified as dividends. Do not issueForm 1099-DIV for dividends received by thecorporation that are allocated to shareholderson line 4b of Schedule K-1.

For more information, see the separate

Instructions for Forms 1099, 1098, 5498, andW-2G.

Note: Every corporation must file Forms1099-MISC if it makes payments of rents,commissions, or other fixed or determinableincome (see section 6041) totaling $600 ormore to any one person in the course of itstrade or business during the calendar year.q Form 5471, Information Return of U.S.Persons With Respect to Certain ForeignCorporations. A corporation may have to fileForm 5471 if any of the following applies:

1. It controls a foreign corporation.

2. It acquires, disposes of, or owns 5% ormore in value of the outstanding stock of aforeign corporation.

3. It owns stock in a corporation that is acontrolled foreign corporation for anuninterrupted period of 30 days or more duringany tax year of the foreign corporation, and itowned that stock on the last day of that year.q Form 5713, International Boycott Report.Every corporation that had operations in, orrelated to, a boycotting country, company, ornational of a country must file Form 5713 toreport those operations and figure the loss ofcertain tax benefits.q Form 8264, Application for Registration of aTax Shelter. Tax shelter organizers must fileForm 8264 to register tax shelters with the IRSfor the purpose of receiving a tax shelterregistration number.q Form 8271, Investor Reporting of Tax

Shelter Registration Number. Corporations thathave acquired an interest in a tax shelter thatis required to be registered use Form 8271 toreport the tax shelter's registration number.Attach Form 8271 to any return on which adeduction, credit, loss, or other tax benefitattributable to a tax shelter is taken or anyincome attributable to a tax shelter is reported.q Form 8275, Disclosure Statement. File Form8275 to disclose items or positions, exceptthose contrary to a regulation, that are nototherwise adequately disclosed on a tax return.The disclosure is made to avoid the parts of theaccuracy-related penalty imposed for disregard

of rules or substantial understatement of tax.Form 8275 is also used for disclosures relatingto preparer penalties for understatements dueto unrealistic positions or disregard of rules.q Form 8275-R, Regulation DisclosureStatement, is used to disclose any item on atax return for which a position has been takenthat is contrary to Treasury regulations.q Form 8281, Information Return for PubliclyOffered Original Issue Discount Instruments.This form is used by issuers of publicly offereddebt instruments having OID to provide theinformation required by section 1275(c).q Forms 8288 and 8288-A, U.S. WithholdingTax Return for Dispositions by Foreign Personsof U.S. Real Property Interests; and Statementof Withholding on Dispositions by ForeignPersons of U.S. Real Property Interests. Usethese forms to report and transmit withheld taxon the sale of U.S. real property by a foreignperson. See section 1445 and the relatedregulations for additional information.q Form 8300, Report of Cash Payments Over$10,000 Received in a Trade or Business. Filethis form to report the receipt of more than$10,000 in cash or foreign currency in onetransaction (or a series of related transactions).q Form 8594, Asset Acquisition Statement.Both the purchaser and seller of a group ofassets constituting a trade or business must filethis form if section 197 intangibles attach, orcould attach, to such assets and if thepurchaser's basis in the assets is determinedonly by the amount paid for the assets.q Form 8697, Interest Computation Under theLook-Back Method for Completed Long-TermContracts. Certain S corporations that are notclosely held may have to file Form 8697. Form8697 is used to figure the interest due or to berefunded under the look-back method ofsection 460(b)(2) on certain long-termcontracts that are accounted for under eitherthe percentage of completion-capitalized costmethod or the percentage of completionmethod. Closely held corporations should seethe instructions on page 20 for line 23, item 10,of Schedule K-1 for details on the Form 8697information they must provide to theirshareholders.

Statements

Stock ownership in foreign corporations. Ifthe corporation owned at least 5% in value ofthe outstanding stock of a foreign personalholding company, and the corporation wasrequired to include in its gross income anyundistributed foreign personal holding companyincome, attach the statement required bysection 551(c).

Transfers to a corporation controlled by thetransferor. If a person receives stock of acorporation in exchange for property, and nogain or loss is recognized under section 351,the transferor and transferee must each attachto their tax returns the information required byRegulations section 1.351-3.

Attachments

Attach Form 4136, Credit for Federal Tax Paidon Fuels, after page 4, Form 1120S. Attachschedules in alphabetical order and other formsin numerical order after Form 4136.

To assist us in processing the return, pleasecomplete every applicable entry space onForm 1120S and Schedule K-1. If you attachstatements, do not write See attached insteadof completing the entry spaces on Form 1120Sand Schedule K-1.

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If you need more space on the forms orschedules, attach separate sheets. Use thesame size and format as on the printed forms.But show the totals on the printed forms.Attach these separate sheets after all theschedules and forms. Be sure to put thecorporation's name and employer identificationnumber (EIN) on each sheet.

Amended Return

To correct an error on a Form 1120S alreadyfiled, file an amended Form 1120S and check

box F(4). If the amended return results in achange to income, or a change in thedistribution of any income or other informationprovided any shareholder, an amendedSchedule K-1 (Form 1120S) must also be filedwith the amended Form 1120S and given tothat shareholder. Be sure to check box D(2) oneach Schedule K-1 to indicate that it is anamended Schedule K-1.

A change to the corporation's Federal returnmay affect its state return. This includeschanges made as the result of an IRSexamination of Form 1120S. For moreinformation, contact the state tax agency for thestate in which the corporation's return was filed.

Passive Activity Limitations

In general, section 469 limits the amount oflosses, deductions, and credits thatshareholders may claim from passiveactivities. The passive activity limitations donot apply to the corporation. Instead, they applyto each shareholder's share of any income orloss and credit attributable to a passive activity.Because the treatment of each shareholder'sshare of corporate income or loss and creditdepends upon the nature of the activity thatgenerated it, the corporation must reportincome or loss and credits separately for eachactivity.

The instructions below (pages 6 through 9)and the instructions for Schedules K and K-1(pages 14 through 20) explain the applicablepassive activity limitation rules and specify the

type of information the corporation mustprovide to its shareholders for each activity. Ifthe corporation had more than one activity, itmust report information for each activity on anattachment to Schedules K and K-1.

Generally, passive activities include (a)activities that involve the conduct of a trade orbusiness in which the shareholder does notmaterially participate and (b) any rental activity(defined below) even if the shareholdermaterially participates. For exceptions, seeActivities That Are Not Passive Activitiesbelow. The level of each shareholder'sparticipation in an activity must be determinedby the shareholder.

The passive activity rules provide that lossesand credits from passive activities can

generally be applied only against income andtax from passive activities. Thus, passivelosses and credits cannot be applied againstincome from salaries, wages, professionalfees, or a business in which the shareholdermaterially participates; against portfolioincome (defined on page 7); or against the taxrelated to any of these types of income.

Special rules require that net income fromcertain activities that would otherwise betreated as passive income must berecharacterized as nonpassive income forpurposes of the passive activity limitations.

To allow each shareholder to apply thepassive activity limitations at the individuallevel, the corporation must report income orloss and credits separately for each of thefollowing: trade or business activities, rentalreal estate activities, rental activities other thanrental real estate, and portfolio income.

Activities That Are Not PassiveActivities

Passive activities do not include:

1. Trade or business activities in which theshareholder materially participated for the taxyear.

2. Any rental real estate activity in whichthe shareholder materially participated and metboth of the following conditions for the tax year:

a. More than half of the personal servicesthe shareholder performed in trades orbusinesses were performed in real propertytrades or businesses in which he or shematerially participated, and

b. The shareholder performed more than750 hours of services in real property tradesor businesses in which he or she materiallyparticipated.

For purposes of this rule, each interest inrental real estate is a separate activity unlessthe shareholder elects to treat all interests in

rental real estate as one activity.If the shareholder is married filing jointly,

either the shareholder or his or her spousemust separately meet both of the aboveconditions, without taking into account servicesperformed by the other spouse.

A real property trade or business is any realproperty development, redevelopment,construction, reconstruction, acquisition,conversion, rental, operation, management,leasing, or brokerage trade or business.Services the shareholder performed as anemployee are not treated as performed in areal property trade or business unless he orshe owned more than 5% of the stock in theemployer.

3. The rental of a dwelling unit used by a

shareholder for personal purposes during theyear for more than the greater of 14 days or10% of the number of days that the residencewas rented at fair rental value.

4. An activity of trading personal propertyfor the account of owners of interests in theactivity. See Temporary Regulations section1.469-1T(e)(6).

Note: The section 469(c)(3) exception for aworking interest in oil and gas properties is notapplicable to an S corporation because statelaw generally limits the liability of corporateshareholders.

Trade or Business Activities

A trade or business activity is an activity (otherthan a rental activity or an activity treated asincidental to an activity of holding property forinvestment) that

1. Involves the conduct of a trade orbusiness (within the meaning of section 162),

2. Is conducted in anticipation of starting atrade or business, or

3. Involves research or experimentalexpenditures deductible under section 174 (orthat would be if you chose to deduct rather thancapitalize them).

If the shareholder does not materiallyparticipate in the activity, a trade or businessactivity of the corporation is a passive activityfor the shareholder.

Each shareholder must determine if he orshe materially participated in an activity. As aresult, while the corporation's overall trade orbusiness income (loss) is reported on page 1of Form 1120S, the specific income anddeductions from each separate trade orbusiness activity must be reported onattachments to Form 1120S. Similarly, whileeach shareholder's allocable share of thecorporation's overall trade or business income(loss) is reported on line 1 of Schedule K-1,each shareholder's allocable share of theincome and deductions from each trade or

business activity must be reported onattachments to each Schedule K-1. SeePassive Activity Reporting Requirements onpage 8 for more information.

Rental Activities

Generally, except as noted below, if the grossincome from an activity consists of amountspaid principally for the use of real or personaltangible property held by the corporation, theactivity is a rental activity.

There are several exceptions to this generalrule. Under these exceptions, an activityinvolving the use of real or personal tangibleproperty is not a rental activity if any of thefollowing apply:q The average period of customer use (defined

below) for such property is 7 days or less.q The average period of customer use for suchproperty is 30 days or less and significantpersonal services (defined below) are providedby or on behalf of the corporation.q Extraordinary personal services (defined onpage 7) are provided by or on behalf of thecorporation.q Rental of the property is treated as incidentalto a nonrental activity of the corporation underTemporary Regulations section1.469-1T(e)(3)(vi) and Regulations section1.469-1(e)(3)(vi).q The corporation customarily makes theproperty available during defined businesshours for nonexclusive use by various

customers.q The corporation provides property for use ina nonrental activity of a partnership in itscapacity as an owner of an interest in suchpartnership. Whether the corporation providesproperty used in an activity of a partnership inthe corporation's capacity as an owner of aninterest in the partnership is based on all thefacts and circumstances.

In addition, a guaranteed payment describedin section 707(c) is not income from a rentalactivity under any circumstances.

Average period of customer use. Figure theaverage period of customer use of property bydividing the total number of days in all rentalperiods by the number of rentals during the taxyear. If the activity involves renting more than

one class of property, multiply the averageperiod of customer use of each class by theratio of the gross rental income from that classto the activity's total gross rental income. Theactivity's average period of customer useequals the sum of these class-by-class averageperiods weighted by gross income. SeeRegulations section 1.469-1(e)(3)(iii).

Significant personal services. Personalservices include only services performed byindividuals. In determining whether personalservices are significant personal services,consider all of the relevant facts andcircumstances. Relevant facts andcircumstances include how often the services

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are provided, the type and amount of laborrequired to perform the services, and the valueof the services in relation to the amountcharged for the use of the property.

The following services are not considered indetermining whether personal services aresignificant:q Services necessary to permit the lawful useof the rental property.q Services performed in connection withimprovements or repairs to the rental propertythat extend the useful life of the propertysubstantially beyond the average rental period.q Services provided in connection with the useof any improved real property that are similarto those commonly provided in connection withlong-term rentals of high-grade commercial orresidential property. Examples include cleaningand maintenance of common areas, routinerepairs, trash collection, elevator service, andsecurity at entrances.

Extraordinary personal services. Servicesprovided in connection with making rentalproperty available for customer use areextraordinary personal services only if theservices are performed by individuals and thecustomers' use of the rental property isincidental to their receipt of the services. Forexample, a patient's use of a hospital roomgenerally is incidental to the care that thepatient receives from the hospital's medicalstaff. Similarly, a student's use of a dormitoryroom in a boarding school is incidental to thepersonal services provided by the school'steaching staff.

Rental property incidental to a nonrentalactivity. An activity is not a rental activity if therental of the property is incidental to anonrental activity, such as the activity ofholding property for investment, a trade orbusiness activity, or the activity of dealing inproperty.

Rental of property is incidental to an activityof holding property for investment if both of thefollowing apply:q The main purpose for holding the property is

to realize a gain from the appreciation of theproperty.q The gross rental income from such propertyfor the tax year is less than 2% of the smallerof the property's unadjusted basis or its fairmarket value.

Rental of property is incidental to a trade orbusiness activity if all of the following apply:q The corporation owns an interest in the tradeor business at all times during the year.q The rental property was mainly used in thetrade or business activity during the tax yearor during at least 2 of the 5 preceding taxyears.q The gross rental income from the property isless than 2% of the smaller of the property'sunadjusted basis or its fair market value.

The sale or exchange of property that is alsorented during the tax year (where the gain orloss is recognized) is treated as incidental tothe activity of dealing in property if, at the timeof the sale or exchange, the property was heldprimarily for sale to customers in the ordinarycourse of the corporation's trade or business.

See Temporary Regulations section1.469-1T(e)(3) and Regulations section1.469-1(e)(3) for more information on thedefinition of rental activities for purposes of thepassive activity limitations.

Reporting of rental activities. In reporting thecorporation's income or losses and credits from

rental activities, the corporation mustseparately report (a) rental real estate activitiesand (b) rental activities other than rental realestate activities.

Shareholders who actively participate in arental real estate activity may be able to deductpart or all of their rental real estate losses (andthe deduction equivalent of rental real estatecredits) against income (or tax) fromnonpassive activities. Generally, the combinedamount of rental real estate losses and thededuction equivalent of rental real estatecredits from all sources (including rental real

estate activities not held through thecorporation) that may be claimed is limited to$25,000.

Report rental real estate activity income(loss) on Form 8825, Rental Real EstateIncome and Expenses of a Partnership or anS Corporation, and on line 2 of Schedules Kand K-1 rather than on page 1 of Form 1120S.Report credits related to rental real estateactivities on lines 12c and 12d and low-incomehousing credits on line 12b of Schedules K andK-1.

Report income (loss) from rental activitiesother than rental real estate on line 3 andcredits related to rental activities other thanrental real estate on line 12e of Schedules Kand K-1.

Portfolio Income

Generally, portfolio income includes all grossincome, other than income derived in theordinary course of a trade or business, that isattributable to interest; dividends; royalties;income from a real estate investment trust, aregulated investment company, a real estatemortgage investment conduit, a common trustfund, a controlled foreign corporation, aqualified electing fund, or a cooperative;income from the disposition of property thatproduces income of a type defined as portfolioincome; and income from the disposition ofproperty held for investment.

Solely for purposes of the precedingparagraph, gross income derived in the

ordinary course of a trade or business includes(and portfolio income, therefore, does notinclude) only the following types of income:q Interest income on loans and investmentsmade in the ordinary course of a trade orbusiness of lending money.q Interest on accounts receivable arising fromthe performance of services or the sale ofproperty in the ordinary course of a trade orbusiness of performing such services or sellingsuch property, but only if credit is customarilyoffered to customers of the business.q Income from investments made in theordinary course of a trade or business offurnishing insurance or annuity contracts orreinsuring risks underwritten by insurancecompanies.q Income or gain derived in the ordinary courseof an activity of trading or dealing in anyproperty if such activity constitutes a trade orbusiness (unless the dealer held the propertyfor investment at any time before such incomeor gain is recognized).q Royalties derived by the taxpayer in theordinary course of a trade or business oflicensing intangible property.q Amounts included in the gross income of apatron of a cooperative by reason of anypayment or allocation to the patron based onpatronage occurring with respect to a trade orbusiness of the patron.

q Other income identified by the IRS as incomederived by the taxpayer in the ordinary courseof a trade or business.

See Temporary Regulations section1.469-2T(c)(3) for more information on portfolioincome.

Report portfolio income on line 4 ofSchedules K and K-1, rather than on page 1of Form 1120S.

Report deductions related to portfolioincome on line 9 of Schedules K and K-1.

Grouping Activities

Generally, one or more trade or businessactivities or rental activities may be treated asa single activity if the activities make up anappropriate economic unit for measurement ofgain or loss under the passive activity rules.Whether activities make up an appropriateeconomic unit depends on all the relevant factsand circumstances. The factors given thegreatest weight in determining whetheractivities make up an appropriate economicunit are

1. Similarities and differences in types oftrades or businesses,

2. The extent of common control,

3. The extent of common ownership,

4. Geographical location, and

5. Reliance between or among theactivities.

Example: The corporation has a significantownership interest in a bakery and a movietheater in Baltimore and in a bakery and amovie theater in Philadelphia. Depending onthe relevant facts and circumstances, theremay be more than one reasonable method forgrouping the corporation's activities. Forinstance, the following groupings may or maynot be permissible: a single activity, a movietheater activity and a bakery activity, aBaltimore activity and a Philadelphia activity,or four separate activities.

Once the corporation chooses a groupingunder these rules, it must continue using thatgrouping in later tax years unless a materialchange in the facts and circumstances makesit clearly inappropriate.

The IRS may regroup the corporation'sactivities if the corporation's grouping fails toreflect one or more appropriate economic unitsand one of the primary purposes for thegrouping is to avoid the passive activitylimitations.

Limitation on grouping certain activities.The following activities may not be groupedtogether

1. A rental activity with a trade or businessactivity unless the activities being groupedtogether make up an appropriate economicunit, and

a. The rental activity is insubstantial relative

to the trade or business activity or vice versa,or

b. Each owner of the trade or businessactivity has the same proportionate ownershipinterest in the rental activity. If so, the portionof the rental activity involving the rental ofproperty to be used in the trade or businessactivity may be grouped with the trade orbusiness activity.

2. An activity involving the rental of realproperty with an activity involving the rental ofpersonal property (except for personal propertyprovided in connection with real property), orvice versa.

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3. Any activity with another activity in adifferent type of business and in which thecorporation holds an interest as a limitedpartner or as a limited entrepreneur (as definedin section 464(e)(2)) if that other activityengages in holding, producing, or distributingmotion picture films or videotapes; farming;leasing section 1245 property; or exploring for(or exploiting) oil and gas resources orgeothermal deposits.

Activities conducted through partnerships.Once a partnership determines its activitiesunder these rules, the corporation as a partner

may use these rules to group those activitieswith each other, with activities conducteddirectly by the corporation, and with activitiesconducted through other partnerships. Thecorporation may not treat as separate activitiesthose activities grouped together by thepartnership.

Recharacterization of Passive Income

Under Temporary Regulations section1.469-2T(f) and Regulations section 1.469-2(f),net passive income from certain passiveactivities must be treated as nonpassiveincome. Net passive income is the excess ofan activity's passive activity gross income overits passive activity deductions (current yeardeductions and prior year unallowed losses).

Income from the following six sources issubject to recharacterization. Note that any netpassive income recharacterized as nonpassiveincome is treated as investment income forpurposes of figuring investment interestexpense limitations if it is from (a) an activityof renting substantially nondepreciable propertyfrom an equity-financed lending activity or (b)an activity related to an interest in apass-through entity that licenses intangibleproperty.

1.Significant participation passiveactivities. A significant participation passiveactivity is any trade or business activity inwhich the shareholder both participates formore than 100 hours during the tax year anddoes not materially participate. Because each

shareholder must determine his or her level ofparticipation, the corporation will not be able toidentify significant participation passiveactivities.

2.Certain nondepreciable rentalproperty activities. Net passive income froma rental activity is nonpassive income if lessthan 30% of the unadjusted basis of theproperty used or held for use by customers inthe activity is subject to depreciation undersection 167.

3.Passive equity-financed lendingactivities. If the corporation has net incomefrom a passive equity-financed lending activity,the smaller of the net passive income orequity-financed interest income from theactivity is nonpassive income.

Note: The amount of income from theactivities in items1 through3above that anyshareholder will be required to recharacterizeas nonpassive income may be limited underTemporary Regulations section 1.469-2T(f)(8).Because the corporation will not haveinformation regarding all of a shareholder'sactivities, it must identify all corporate activitiesmeeting the definitions in items2and3asactivities that may be subject torecharacterization.

4.Rental activities incidental to adevelopment activity. Net rental activityincome is nonpassive income for a shareholderif all of the following apply: (a) the corporation

recognizes gain from the sale, exchange, orother disposition of the rental property duringthe tax year; (b) the use of the item of propertyin the rental activity started less than 12months before the date of disposition (the useof an item of rental property begins on the firstday on which (i) the corporation owns aninterest in the property, (ii) substantially all ofthe property is either rented or held out for rentand ready to be rented, and (iii) no significantvalue-enhancing services remain to beperformed); and (c) the shareholder materiallyparticipated or significantly participated for any

tax year in an activity that involved theperformance of services for the purpose ofenhancing the value of the property (or anyother item of property, if the basis of theproperty disposed of is determined in whole orin part by reference to the basis of that item ofproperty). Net rental activity income is theexcess of passive activity gross income fromrenting or disposing of property over passiveactivity deductions (current year deductionsand prior year unallowed losses) that arereasonably allocable to the rented property.

Because the corporation cannot determinea shareholder's level of participation, thecorporation must identify net income fromproperty described in items (a) and (b) aboveas income that may be subject to

recharacterization.5.Activities involving property rented to

a nonpassive activity. If a taxpayer rentsproperty to a trade or business activity in whichthe taxpayer materially participates, thetaxpayer's net rental activity income (definedabove) from the property is nonpassive income.

6.Acquisition of an interest in apass-through entity that licenses intangibleproperty. Generally, net royalty income fromintangible property is nonpassive income if thetaxpayer acquired an interest in thepass-through entity after it created theintangible property or performed substantialservices or incurred substantial costs indeveloping or marketing the intangibleproperty. Net royalty income is the excess of

passive activity gross income from licensing ortransferring any right in intangible property overpassive activity deductions (current yeardeductions and prior year unallowed losses)that are reasonably allocable to the intangibleproperty.

See Temporary Regulations section1.469-2T(f)(7)(iii) for exceptions to this rule.

Passive Activity ReportingRequirements

To allow shareholders to correctly apply thepassive activity loss and credit limitation rules,any corporation that carries on more than oneactivity must:

1. Provide an attachment for each activityconducted through the corporation that

identifies the type of activity conducted (tradeor business, rental real estate, rental activityother than rental real estate, or investment).

2. On the attachment for each activity,provide a schedule, using the same linenumbers as shown on Schedule K-1, detailingthe net income (loss), credits, and all itemsrequired to be separately stated under section1366(a)(1) from each trade or business activity,from each rental real estate activity, from eachrental activity other than a rental real estateactivity, and from investments.

3. Identify the net income (loss) and theshareholder's share of corporation interest

expense from each activity of renting a dwellingunit that any shareholder uses for personalpurposes during the year for more than thegreater of 14 days or 10% of the number ofdays that the residence is rented at fair rentalvalue.

4. Identify the net income (loss) and theshareholder's share of interest expense fromeach activity of trading personal propertyconducted through the corporation.

5. For any gain (loss) from the dispositionof an interest in an activity or of an interest inproperty used in an activity (including

dispositions before 1987 from which gain isbeing recognized after 1986):

a. Identify the activity in which the propertywas used at the time of disposition;

b. If the property was used in more thanone activity during the 12 months preceding thedisposition, identify the activities in which theproperty was used and the adjusted basisallocated to each activity; and

c. For gains only, if the property wassubstantially appreciated at the time of thedisposition and the applicable holding periodspecified in Regulations section1.469-2(c)(2)(iii)(A) was not satisfied, identifythe amount of the nonpassive gain and indicatewhether or not the gain is investment incomeunder Regulations section 1.469-2(c)(2)(iii)(F).

6. Specify the amount of gross portfolioincome, the interest expense properly allocableto portfolio income, and expenses other thaninterest expense that are clearly and directlyallocable to portfolio income.

7. Identify the ratable portion of any section481 adjustment (whether a net positive or a netnegative adjustment) allocable to eachcorporate activity.

8. Identify any gross income from sourcesspecifically excluded from passive activitygross income, including:

a. Income from intangible property, if theshareholder is an individual whose personalefforts significantly contributed to the creationof the property;

b. Income from state, local, or foreignincome tax refunds; and

c. Income from a covenant not to compete,if the shareholder is an individual whocontributed the covenant to the corporation.

9. Identify any deductions that are notpassive activity deductions.

10. If the corporation makes a full or partialdisposition of its interest in another entity,identify the gain (loss) allocable to each activityconducted through the entity, and the gainallocable to a passive activity that would havebeen recharacterized as nonpassive gain hadthe corporation disposed of its interest inproperty used in the activity (because theproperty was substantially appreciated at thetime of the disposition, and the gainrepresented more than 10% of theshareholder's total gain from the disposition).

11. Identify the following items that may besubject to the recharacterization rules underTemporary Regulations section 1.469-2T(f) andRegulations section 1.469-2(f):

a. Net income from an activity of rentingsubstantially nondepreciable property;

b. The smaller of equity-financed interestincome or net passive income from anequity-financed lending activity;

c. Net rental activity income from propertydeveloped (by the shareholder or the

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corporation), rented, and sold within 12 monthsafter the rental of the property commenced;

d. Net rental activity income from the rentalof property by the corporation to a trade orbusiness activity in which the shareholder hadan interest (either directly or indirectly); and

e. Net royalty income from intangibleproperty if the shareholder acquired theshareholder's interest in the corporation afterthe corporation created the intangible propertyor performed substantial services or incurredsubstantial costs in developing or marketing theintangible property.

12. Identify separately the credits from eachactivity conducted by or through thecorporation.

Specific Instructions

General Information

Name, Address, and EmployerIdentification Number

Use the label that was mailed to thecorporation. Cross out any errors and print thecorrect information on the label.

Name. If the corporation did not receive a

label, print or type the corporation's true name(as set forth in the corporate charter or otherlegal document creating it).

Address. Include the suite, room, or other unitnumber after the street address. If apreaddressed label is used, please include theinformation on the label. If the Post Office doesnot deliver to the street address and thecorporation has a P.O. box, show the boxnumber instead of the street address.

If the corporation changes its mailingaddress after filing its return, it can notify theIRS by filing Form 8822, Change of Address.

Employer identification number (EIN). Showthe correct EIN in item C on page 1 of Form1120S.

Item BBusiness Code No.See Codes for Principal Business Activityon page 23 of these instructions.

Item ETotal Assets

Enter the corporation's total assets at the endof the tax year, as determined by theaccounting method regularly used inmaintaining the corporation's books andrecords. If there were no assets at the end ofthe tax year, enter the total assets as of thebeginning of the tax year. If the S electionterminated during the tax year, see theinstructions for Schedule L on page 21 forspecial rules that may apply when figuring thecorporation's year end assets.

Item FInitial Return, Final Return,Change in Address, and AmendedReturn

If this is the corporation's first return, check boxF(1). If the corporation has ceased to exist,check box F(2). Also check box D(1) on eachSchedule K-1 to indicate that it is a finalSchedule K-1. Indicate a change in address bychecking box F(3). If this amends a previouslyfiled return, check box F(4). If Schedules K-1are also being amended, check box D(2) oneach Schedule K-1.

Income

Caution: Report only trade or business activityincome or loss on lines 1a through 6. Do notreport rental activity income or portfolioincome or loss on these lines. (See theinstructions onPassive Activity Limitationsbeginning on page 6 for definitions of rentalincome and portfolio income.) Rental activityincome and portfolio income are reported onSchedules K and K-1 (rental real estateactivities are also reported on Form 8825).

Do not include any tax-exempt income on

lines 1 through 5. A corporation that receivesany exempt income other than interest, orholds any property or engages in an activitythat produces exempt income, reports theamount of this income on line 18 of SchedulesK and K-1.

Report tax-exempt interest income, includingexempt-interest dividends received as ashareholder in a mutual fund or other regulatedinvestment company, on line 17 of SchedulesK and K-1.

See Deductions on page 10 for informationon how to report expenses related totax-exempt income.

If the S corporation has had debt dischargedresulting from a title 11 bankruptcy proceeding,or while insolvent, see Form 982, Reduction

of Tax Attributes Due to Discharge ofIndebtedness, and Pub. 908, Bankruptcy TaxGuide.

Line 1Gross Receipts or Sales

Enter gross receipts or sales from all trade orbusiness operations except those you reporton lines 4 and 5. For reporting advancepayments, see Regulations section 1.451-5. Toreport income from long-term contracts, seesection 460.

Installment sales. Generally, the installmentmethod cannot be used for dealer dispositionsof property. A dealer disposition is anydisposition of personal property by a personwho regularly sells or otherwise disposes ofproperty of the same type on the installment

plan or any disposition of real property held forsale to customers in the ordinary course of thetaxpayer's trade or business. The dispositionof property used or produced in the farmingbusiness is not included as a dealerdisposition. See section 453(l) for details andexceptions.

Enter on line 1a the gross profit oncollections from installment sales for any of thefollowing:q Dealer dispositions of property beforeMarch 1, 1986.q Dispositions of property used or produced inthe trade or business of farming.q Certain dispositions of timeshares andresidential lots reported under the installment

method.Attach a schedule showing the following

information for the current and the 3 precedingyears:q Gross sales.q Cost of goods sold.q Gross profits.q Percentage of gross profits to gross sales.q Amount collected.q Gross profit on the amount collected.

Line 2Cost of Goods Sold

See the instructions for Schedule A.

Line 4Net Gain (Loss) From Form4797

Caution: Include only ordinary gains or lossesfrom the sale, exchange, or involuntaryconversion of assets used in a trade orbusiness activity. Ordinary gains or losses fromthe sale, exchange, or involuntary conversionsof assets used in rental activities are reportedseparately on Schedule K as part of the net

income (loss) from the rental activity in whichthe property was used.

A corporation that is a partner in apartnership must include on Form 4797, Salesof Business Property, its share of ordinarygains (losses) from sales, exchanges, orinvoluntary or compulsory conversions (otherthan casualties or thefts) of the partnership'strade or business assets.

Do not include any recapture of the section179 expense deduction. See the instructionson page 20 for Schedule K-1, line 23, item 3,and the Instructions for Form 4797 for moreinformation.

Line 5Other Income (Loss)

Enter on line 5 trade or business income (loss)

that is not included on lines 1a through 4.Examples of such income include:

1. Interest income derived in the ordinarycourse of the corporation's trade or business,such as interest charged on receivablebalances;

2. Recoveries of bad debts deducted inearlier years under the specific charge-offmethod;

3. Taxable income from insuranceproceeds;

4. The amount of credit figured on Form6478, Credit for Alcohol Used as Fuel;

5. All section 481 income adjustmentsresulting from changes in accounting methods(show the computation on an attached

schedule); and6. Ordinary income (loss) from trade or

business activities of a partnership (fromSchedule K-1 (Form 1065), line 1).

The corporation must include as otherincome the recapture amount for section 280Fif the business use of listed property drops to50% or less. To figure the recapture amount,the corporation must complete Part IV of Form4797.

The corporation must also include in otherincome the amount of any deduction previouslytaken under section 179A that is subject torecapture. The S corporation may have torecapture the benefit of any allowablededuction for qualified clean-fuel vehicleproperty (or clean-fuel vehicle refueling

property), if the property later ceases to qualifyfor the deduction. See Pub. 535, BusinessExpenses, for details on how to figure therecapture.

Do not include items requiring separatecomputations by shareholders that must bereported on Schedules K and K-1. See theinstructions for Schedules K and K-1 beginningon page 14.

If other income consists of only one item,identify it by showing the account caption inparentheses on line 5. A separate scheduleneed not be attached to the return in this case.

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Do not net any expense item (such asinterest) with a similar income item. Report alltrade or business expenses on lines 7 through19.

Deductions

Caution: Reportonlytrade or businessactivity expenses on lines 7 through 19.

Do not report rental activity expenses ordeductions allocable to portfolio income onthese lines. Rental activity expenses areseparately reported on Form 8825 or line 3 of

Schedules K and K-1. Deductions allocable toportfolio income are separately reported on line9 of Schedules K and K-1. See PassiveActivity Limitations beginning on page 6 formore information on rental activities andportfolio income.

Do not report any nondeductible amounts(such as expenses connected with theproduction of tax-exempt income) on lines 7through 19. Instead, report nondeductibleexpenses on line 19 of Schedules K and K-1.If an expense is connected with both taxableincome and nontaxable income, allocate areasonable part of the expense to each kindof income.

Limitations on Deductions

Section 263A uniform capitalization rules.The uniform capitalization rules of section 263Arequire corporations to capitalize or include ininventory certain costs incurred in connectionwith:q The production of real and tangible personalproperty held in inventory or held for sale in theordinary course of business.q Personal property (tangible and intangible)acquired for resale.q The production of property constructed orimproved by a corporation for use in its tradeor business or in an activity engaged in forprofit.

The costs required to be capitalized undersection 263A are not deductible until theproperty to which the costs relate is sold, used,or otherwise disposed of by the corporation.

Exceptions. Section 263A does not applyto:q Personal property acquired for resale if thetaxpayer's average annual gross receipts forthe 3 prior tax years are $10 million or less.q Timber.q Most property produced under a long-termcontract.q Certain property produced in a farmingbusiness. See below.

The corporation must report the followingcosts separately to the shareholders forpurposes of determinations under section59(e):q Research and experimental costs undersection 174.q Intangible drilling costs for oil, gas, andgeothermal property.q Mining exploration and development costs.

Tangible personal propertyproduced by acorporation includes a film, sound recording,video tape, book, or similar property.

Corporations subject to the rules arerequired to capitalize not only direct costs butan allocable portion of most indirect costs(including taxes) that benefit the assetsproduced or acquired for resale.

For inventory, some of the indirect coststhat must be capitalized are:

q Administration expenses.q Taxes.q Depreciation.q Insurance.q Compensation paid to officers attributable toservices.q Rework labor.q Contributions to pension, stock bonus, andcertain profit-sharing, annuity, or deferredcompensation plans.

Regulations section 1.263A-1(e)(3) specifiesother indirect costs that relate to production orresale activities that must be capitalized andthose that may be currently deducted.

Interest expense paid or incurred during theproduction period of certain property must becapitalized and is governed by special rules.For more details, see Regulations sections1.263A-8 through 1.263A-15.

For more details on the uniformcapitalization rules, see Regulations sections1.263A-1 through 1.263A-3.

Special rules for certain corporationsengaged in farming. For S corporations notrequired to use the accrual method ofaccounting, the rules of section 263A do notapply to expenses of raising any:q Animal or

q Plant that has a preproductive period of 2years or less.

Shareholders of S corporations not requiredto use the accrual method of accounting mayelect to currently deduct the preproductiveperiod expenses of certain plants that have apreproductive period of more than 2 years.Because each shareholder makes the electionto deduct these expenses, the corporationshould not capitalize them. Instead, thecorporation should report the expensesseparately on line 21 of Schedule K and eachshareholder's pro rata share on line 23 ofSchedule K-1.

See sections 263A(d) and (e) andTemporary Regulations section 1.263A-4T fordefinitions and other details.

Transactions between related taxpayers.Generally, an accrual basis S corporation maydeduct business expenses and interest owedto a related party (including any shareholder)only in the tax year of the corporation thatincludes the day on which the payment isincludible in the income of the related party.See section 267 for details.

Section 291 limitations. If the S corporationwas a C corporation for any of the 3immediately preceding years, the corporationmay be required to adjust deductions allowedto the corporation for depletion of iron ore andcoal, and the amortizable basis of pollutioncontrol facilities. See section 291 to determinethe amount of the adjustment.

Business start-up expenses. Business

start-up expenses must be capitalized. Anelection may be made to amortize them overa period of not less than 60 months. Seesection 195.

Reducing certain expenses for whichcredits are allowable. For each of the creditslisted below, the corporation must reduce theotherwise allowable deductions for expensesused to figure the credit by the amount of thecurrent year credit:

1. The work opportunity credit,

2. The welfare-to-work credit,

3. The credit for increasing researchactivities,

4. The enhanced oil recovery credit,

5. The disabled access credit,

6. The empowerment zone employmentcredit,

7. The Indian employment credit,

8. The credit for employer social securityand Medicare taxes paid on certain employeetips, and

9. The orphan drug credit.

If the corporation has any of these credits,be sure to figure each current year creditbefore figuring the deductions for expenses on

which the credit is based.

Line 7Compensation of Officers

Enter on line 7 the total compensation of allofficers paid or incurred in the trade orbusiness activities of the corporation, includingfringe benefit expenditures made on behalf ofofficers owning more than 2% of thecorporation's stock. Also report these fringebenefits as wages in box 1 of Form W-2. Donot include on line 7 amounts paid or incurredfor fringe benefits of officers owning 2% or lessof the corporation's stock. These amounts arereported on line 18, page 1, of Form 1120S.See the instructions for that line for informationon the types of expenditures that are treatedas fringe benefits and for the stock ownership

rules.Report amounts paid for health insurance

coverage for a more than 2% shareholder(including that shareholder's spouse anddependents) as an information item in box 14of that shareholder's Form W-2. For 1997, amore than 2% shareholder may be allowed todeduct up to 40% of such amounts on Form1040, line 27.

Do not include on line 7 compensationreported elsewhere on the return, such asamounts included in cost of goods sold,elective contributions to a section 401(k) cashor deferred arrangement, or amountscontributed under a salary reduction SEPagreement.

Line 8Salaries and WagesEnter on line 8 the amount of salaries andwages paid or incurred for the tax year,reduced by any applicable employment creditsfrom Form 5884, Work Opportunity Credit,Form 8861, Welfare-to-Work Credit, Form8844, Empowerment Zone Employment Credit,and Form 8845, Indian Employment Credit.See the instructions for these forms for moreinformation. Include fringe benefit expendituresmade on behalf of employees (other thanofficers) owning more than 2% of thecorporation's stock. Also report these fringebenefits as wages in box 1 of Form W-2. Donot include on line 8 amounts paid or incurredfor fringe benefits of employees owning 2% orless of the corporation's stock. These amounts

are reported on line 18, page 1, of Form1120S. See the instructions for that line forinformation on the types of expenditures thatare treated as fringe benefits and for the stockownership rules.

Report amounts paid for health insurancecoverage for a more than 2% shareholder(including that shareholder's spouse anddependents) as an information item in box 14of that shareholder's Form W-2. For 1997, amore than 2% shareholder may be allowed todeduct up to 40% of such amounts on Form1040, line 27.

Do not include on line 8 salaries and wagesreported elsewhere on the return, such as

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amounts included in cost of goods sold,elective contributions to a section 401(k) cashor deferred arrangement, or amountscontributed under a salary reduction SEPagreement.

If a shareholder or a member of the familyof one or more shareholders of the corporationrenders services or furnishes capital to thecorporation for which reasonable compensationis not paid, the IRS may make adjustments inthe items taken into account by suchindividuals and the value of such services orcapital. See section 1366(e).

Line 9Repairs and Maintenance

Enter the costs of incidental repairs andmaintenance, such as labor and supplies, thatdo not add to the value of the property orappreciably prolong its life, but only to theextent that such costs relate to a trade orbusiness activity and are not claimedelsewhere on the return. New buildings,machinery, or permanent improvements thatincrease the value of the property are notdeductible. They are chargeable to capitalaccounts and may be depreciated oramortized.

Line 10Bad Debts

Enter the total debts that became worthless in

whole or in part during the year, but only to theextent such debts relate to a trade or businessactivity. Report deductible nonbusiness baddebts as a short-term capital loss on ScheduleD (Form 1120S).

Caution: Cash method taxpayers cannot takea bad debt deduction unless the amount waspreviously included in income.

Line 11Rents

If the corporation rented or leased a vehicle,enter the total annual rent or lease expensepaid or incurred in the trade or businessactivities of the corporation. Also complete PartV of Form 4562, Depreciation andAmortization. If the corporation leased a vehiclefor a term of 30 days or more, the deduction for

vehicle lease expense may have to be reducedby an amount called the inclusion amount.The corporation may have an inclusion amountif

See Pub. 463 for instructions on figu