(a) In general. Under section 996(b), if for any taxable year a DISC, or a former DISC, incurs a deficit in earnings and profits, such deficit shall be charged—
(1) First, to other earnings and profits (as defined in § 1.996-3(d)) to the extent thereof,
(2) Second, to accumulated DISC income (as defined in § 1.996-3(b)) to the extent thereof, subject to the special rule in paragraph (b) of this section,
(3) Third, to previously taxed income (as defined in § 1.996-3(c)) to the extent thereof, and
(4) To the extent that the amount of such deficit exceeds the sum of the amounts charged in accordance with subparagraphs (1), (2), and (3) of this paragraph, to other earnings and profits (as defined in § 1.996-3(d)).
(b) Deficits subsequent to a disqualification. A deficit in earnings and profits of a DISC, or former DISC, shall not be charged to accumulated DISC income which has been determined is to be deemed distributed to the shareholders pursuant to § 1.995-3 as a result of a revocation of election or other disqualification. Thus, in accordance with paragraph (a) of this section as modified by this paragraph, a deficit incurred by a former DISC following such a revocation or disqualification shall be charged first to other earnings and profits and then to previously taxed income with any balance being charged to other earnings and profits and creating a deficit therein. The preceding sentence shall also apply in the case of a deficit incurred by a DISC which has no accumulated DISC income accumulated during its current taxable year and all immediately preceding consecutive taxable years for which it was a DISC. If as a result of the application of this paragraph the amount of a deficit in other earnings and profits exceeds the amount of a deficit in accumulated earnings and profits, then upon any subsequent actual distribution the deficit in other earnings and profits shall be reduced by the lower of (1) the amount of such actual distribution chargeable to accumulated DISC income or previously taxed income or (2) the amount of such excess.
(c) Examples. The provisions of this section may be illustrated by the following examples:
X Corporation, which uses the calendar year as its taxable year, becomes a DISC beginning with 1976. In addition to other facts assumed in the table below, X incurs a deficit in earnings and profits for 1979 of $70. Such deficit is charged to the divisions of X's earnings and profits pursuant to paragraph (a) of this section in the manner set forth in such table.
| Accumulated DISC income | Previously taxed income | Other earnings and profits | |
|---|---|---|---|
| Balance January 1, 1976 | $50 | ||
| Increase for 1976 | $10 | $8 | |
| Increase for 1977 | 10 | 8 | |
| Increase for 1978 | 10 | 8 | |
| Balance January 1, 1979 | 30 | 24 | 50 |
| Deficit for 1979 of $70: | |||
| Charge No. 1 | (50) | ||
| Charge No. 2 | (20) | ||
| Balance January 1, 1980 | 10 | 0 |
Assume the same facts as in example 1, except that effective for taxable years beginning with 1979, X revokes its election to be treated as a DISC. Under § 1.995-3, X has $30 of accumulated DISC income which is to be deemed distributed $10 per year in 1980, 1981, and 1982. The deficit in earnings and profits for 1979 is charged to the divisions of X's earnings and profits pursuant to paragraph (b) of this section in the manner set forth in the table below:
| Accumulated DISC income | Previously taxed income | Other earnings and profits | |
|---|---|---|---|
| Balance January 1, 1979 | $30 | $24 | $50 |
| Deficit for 1979 of $70: | |||
| Charge No. 1 | (50) | ||
| Charge No. 2 | (20) | ||
| Balance January 1, 1980 | 30 | 4 | 0 |
Assume the same facts as in example 2, except that the deficit in earnings and profits for 1979 is $120. Assume further that for 1980, 1981, and 1982, during which years X's shareholders are receiving scheduled installments of the deemed distributions of accumulated DISC income under § 1.995-3, X, a former DISC, has neither earnings and profits nor a deficit in earnings and profits. The $120 deficit for 1979 is charged to the divisions of X's earnings and profits pursuant to paragraph (b) of this section in the manner set forth in the table below:
| Accumulated DISC income | Previously taxed income | Other earnings and profits | Accumulated earnings and profits | |
|---|---|---|---|---|
| Balance January 1, 1979 | $30 | $24 | $50 | $104 |
| Deficit for 1979 of $120 | (120) | |||
| Charge No. 1 | (50) | |||
| Charge No. 2 | (24) | |||
| Charge No. 3 | (46) | |||
| Balance January 1, 1980 | 30 | 0 | (46) | (16) |
| Deemed distributions in 1980 under § 1.995-3 | (10) | 10 | ||
| Balance January 1, 1981 | 20 | 10 | (46) | (16) |
Assume the same facts as in example 3, except that on December 31, 1980, X makes an actual distribution of $10 out of previously taxed income. On January 1, 1981, X has $20 of accumulated DISC income, no previously taxed income, and a deficit of $36 in other earnings and profits. The deficit of $16 in accumulated earnings and profits remains the same.
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