[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2011 Edition]
[From the U.S. Government Printing Office]



[[Page 1]]

          

          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.301 to 1.400)

                         Revised as of April 1, 2011

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2011
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as a 
                    Special Edition of the Federal Register

[[Page ii]]

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                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     635
      Alphabetical List of Agencies Appearing in the CFR......     655
      Table of OMB Control Numbers............................     665
      List of CFR Sections Affected...........................     683

[[Page iv]]





                     ----------------------------

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.301-1 
                       refers to title 26, part 
                       1, section 301-1.

                     ----------------------------

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2011), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
dates and effective dates are usually not the same and care must be 
exercised by the user in determining the actual effective date. In 
instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
inserted following the text.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
amendments to existing regulations in the CFR. These OMB numbers are 
placed as close as possible to the applicable recordkeeping or reporting 
requirements.

OBSOLETE PROVISIONS

    Provisions that become obsolete before the revision date stated on 
the cover of each volume are not carried. Code users may find the text 
of provisions in effect on a given date in the past by using the 
appropriate numerical list of sections affected. For the period before 
April 1, 2001, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, 1973-1985, or 1986-2000, published in eleven separate 
volumes. For the period beginning April 1, 2001, a ``List of CFR 
Sections Affected'' is published at the end of each CFR volume.

``[RESERVED]'' TERMINOLOGY

    The term ``[Reserved]'' is used as a place holder within the Code of 
Federal Regulations. An agency may add regulatory information at a 
``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used 
editorially to indicate that a portion of the CFR was left vacant and 
not accidentally dropped due to a printing or computer error.

INCORPORATION BY REFERENCE

    What is incorporation by reference? Incorporation by reference was 
established by statute and allows Federal agencies to meet the 
requirement to publish regulations in the Federal Register by referring 
to materials already published elsewhere. For an incorporation to be 
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if it were published in full in the Federal Register (5 U.S.C. 552(a)). 
This material, like any other properly issued regulation, has the force 
of law.
    What is a proper incorporation by reference? The Director of the 
Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
approval is based are:
    (a) The incorporation will substantially reduce the volume of 
material published in the Federal Register.
    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
process.
    (c) The incorporating document is drafted and submitted for 
publication in accordance with 1 CFR part 51.
    What if the material incorporated by reference cannot be found? If 
you have any problem locating or obtaining a copy of material listed as 
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CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Authorities 
and Rules. A list of CFR titles, chapters, subchapters, and parts and an 
alphabetical list of agencies publishing in the CFR are also included in 
this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.

[[Page vii]]

    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

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in the Code of Federal Regulations.

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, 8601 Adelphi Road, College Park, MD 
20740-6001 or e-mail fedreg.info@nara.gov.

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register.

    Raymond A. Mosley,
    Director,
    Office of the Federal Register.
    April 1, 2011.







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2011. The first thirteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Sec. Sec.  1.0-1.60; 
Sec. Sec.  1.61-1.169; Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; 
Sec. Sec.  1.401-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end. The fourteenth volume containing parts 2-29, includes the remainder 
of subchapter A and all of Subchapter B--Estate and Gift Taxes. The last 
six volumes contain parts 30-39 (Subchapter C--Employment Taxes and 
Collection of Income Tax at Source); parts 40-49; parts 50-299 
(Subchapter D--Miscellaneous Excise Taxes); parts 300-499 (Subchapter 
F--Procedure and Administration); parts 500-599 (Subchapter G--
Regulations under Tax Conventions); and part 600 to end (Subchapter H--
Internal Revenue Practice).

    The OMB control numbers for Title 26 appear in Sec.  602.101 of this 
chapter. For the convenience of the user, Sec.  602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

    For this volume, Robert J. Sheehan, III was Chief Editor. The Code 
of Federal Regulations publication program is under the direction of 
Michael L. White, assisted by Ann Worley.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




         (This book contains part 1, Sec. Sec. 1.301 to 1.400)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




  --------------------------------------------------------------------


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In chapter I cross 
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross reference has been deleted. For further explanation, see 45 FR 
20795, March 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes (continued)....................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations, and Regulations Under Tax Conventions.

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)


PART 1_INCOME TAXES--Table of Contents



                        Normal Taxes and Surtaxes

                 CORPORATE DISTRIBUTIONS AND ADJUSTMENTS

                      DISTRIBUTIONS BY CORPORATIONS

                          Effects on Recipients

Sec.
1.301-1 Rules applicable with respect to distributions of money and 
          other property.
1.302-1 General.
1.302-2 Redemptions not taxable as dividends.
1.302-3 Substantially disproportionate redemption.
1.302-4 Termination of shareholder's interest.
1.303-1 General.
1.303-2 Requirements.
1.303-3 Application of other sections.
1.304-1 General.
1.304-2 Acquisition by related corporation (other than subsidiary).
1.304-3 Acquisition by a subsidiary.
1.304-4 Special rule for the use of related corporations to avoid the 
          application of section 304.
1.304-4T Special rule for the use of related corporations to avoid the 
          application of section 304 (temporary).
1.304-5 Control.
1.305-1 Stock dividends.
1.305-2 Distributions in lieu of money.
1.305-3 Disproportionate distributions.
1.305-4 Distributions of common and preferred stock.
1.305-5 Distributions on preferred stock.
1.305-6 Distributions of convertible preferred.
1.305-7 Certain transactions treated as distributions.
1.305-8 Effective dates.
1.306-1 General
1.306-2 Exception
1.306-3 Section 306 stock defined.
1.307-1 General.
1.307-2 Exception.

                         effects on corporation

1.312-1 Adjustment to earnings and profits reflecting distributions by 
          corporations.
1.312-2 Distribution of inventory assets.
1.312-3 Liabilities.
1.312-4 Examples of adjustments provided in section 312(c).
1.312-5 Special rule for partial liquidations and certain redemptions.
1.312-6 Earnings and profits.
1.312-7 Effect on earnings and profits of gain or loss realized after 
          February 28, 1913.
1.312-8 Effect on earnings and profits of receipt of tax-free 
          distributions requiring adjustment or allocation of basis of 
          stock.
1.312-9 Adjustments to earnings and profits reflecting increase in value 
          accrued before March 1, 1913.
1.312-10 Allocation of earnings in certain corporate separations.
1.312-11 Effect on earnings and profits of certain other tax-free 
          exchanges, tax-free distributions, and tax-free transfers from 
          one corporation to another.
1.312-12 Distributions of proceeds of loans guaranteed by the United 
          States.
1.312-15 Effect of depreciation on earnings and profits.

              definitions; constructive ownership of stock

1.316-1 Dividends.
1.316-2 Sources of distribution in general.
1.317-1 Property defined.
1.318-1 Constructive ownership of stock; introduction.
1.318-2 Application of general rules.
1.318-3 Estates, trusts, and options.
1.318-4 Constructive ownership as actual ownership; exceptions.

                         Corporate Liquidations

                          effects on recipients

1.331-1 Corporate liquidations.
1.332-1 Distributions in liquidation of subsidiary corporation; general.
1.332-2 Requirements for nonrecognition of gain or loss.
1.332-3 Liquidations completed within one taxable year.
1.332-4 Liquidations covering more than one taxable year.
1.332-5 Distributions in liquidation as affecting minority interests.
1.332-6 Records to be kept and information to be filed with return.
1.332-7 Indebtedness of subsidiary to parent.
1.334-1 Basis of property received in liquidations.

                         effects on corporation

1.337(d)-1 Transitional loss limitation rule.
1.337(d)-1T [Reserved]
1.337(d)-2 Loss limitation window period.
1.337(d)-2T Loss limitation window period (temporary).
1.337(d)-4 Taxable to tax-exempt.
1.337(d)-5 Old transitional rules imposing tax on property owned by a C 
          corporation that becomes property of a RIC or REIT .

[[Page 6]]

1.337(d)-6 New transitional rules imposing tax on property owned by a C 
          corporation that becomes property of a RIC or REIT.
1.337(d)-7 Tax on property owned by a C corporation that becomes 
          property of a RIC or REIT.
1.338-0 Outline of topics.
1.338-1 General principles; status of old target and new target.
1.338-2 Nomenclature and definitions; mechanics of the section 338 
          election.
1.338-3 Qualification for the section 338 election.
1.338-4 Aggregate deemed sale price; various aspects of taxation of the 
          deemed asset sale.
1.338-5 Adjusted grossed-up basis.
1.338-6 Allocation of ADSP and AGUB among target assets.
1.338-7 Allocation of redetermined ADSP and AGUB among target assets.
1.338-8 Asset and stock consistency.
1.338-9 International aspects of section 338.
1.338-10 Filing of returns.
1.338-11 Effect of section 338 election on insurance company targets.
1.338(h)(10)-1 Deemed asset sale and liquidation.
1.338(i)-1 Effective/applicability date.

      Collapsible Corporations; Foreign Personal Holding Companies

1.341-1 Collapsible corporations; in general.
1.341-2 Definitions.
1.341-3 Presumptions.
1.341-4 Limitations on application of section.
1.341-5 Application of section.
1.341-6 Exceptions to application of section.
1.341-7 Certain sales of stock of consenting corporations.

                               definition

1.346-1 Partial liquidation.
1.346-2 Treatment of certain redemptions.
1.346-3 Effect of certain sales.

               Corporate Organizations and Reorganizations

                         corporate organizations

1.351-1 Transfer to corporation controlled by transferor.
1.351-2 Receipt of property.
1.351-3 Records to be kept and information to be filed.

              effects on shareholders and security holders

1.354-1 Exchanges of stock and securities in certain reorganizations.
1.355-0 Table of contents.
1.355-0T Outline of sections (temporary).
1.355-1 Distribution of stock and securities of controlled corporation.
1.355-2 Limitations.
1.355-2T Limitations (temporary).
1.355-3 Active conduct of a trade or business.
1.355-4 Non pro rata distributions, etc.
1.355-5 Records to be kept and information to be filed.
1.355-6 Recognition of gain on certain distributions of stock or 
          securities in controlled corporation.
1.355-7 Recognition of gain on certain distributions of stock or 
          securities in connection with an acquisition.
1.356-1 Receipt of additional consideration in connection with an 
          exchange.
1.356-2 Receipt of additional consideration not in connection with an 
          exchange.
1.356-3 Rules for treatment of securities as ``other property''.
1.356-4 Exchanges for section 306 stock.
1.356-5 Transactions involving gift or compensation.
1.356-6 Rules for treatment of nonqualified preferred stock as other 
          property.
1.356-7 Rules for treatment of nonqualified preferred stock and other 
          preferred stock received in certain transactions.
1.357-1 Assumption of liability.
1.357-2 Liabilities in excess of basis.
1.358-1 Basis to distributees.
1.358-2 Allocation of basis among nonrecognition property.
1.358-3 Treatment of assumption of liabilities.
1.358-4 Exceptions.
1.358-5 Special rules for assumption of liabilities.
1.358-6 Stock basis in certain triangular reorganizations.
1.358-7 Transfers by partners and partnerships to corporations.

                         effects on corporation

1.361-1 Nonrecognition of gain or loss to corporations.
1.362-1 Basis to corporations.
1.362-2 Certain contributions to capital.
1.362-4 Limitations on built-in loss duplication.
1.367(a)-1 Transfers to foreign corporations subject to section 367(a): 
          In general.
1.367(a)-1T Transfers to foreign corporations subject to section 367(a): 
          In general (temporary).
1.367(a)-2T Exception for transfers of property for use in the active 
          conduct of a trade or business (temporary).
1.367(a)-3 Treatment of transfers of stock or securities to foreign 
          corporations.
1.367(a)-3T Treatment of transfers of stock or securities to foreign 
          corporations (temporary).
1.367(a)-4T Special rules applicable to specified transfers of property 
          (temporary).
1.367(a)-5T Property subject to section 367(a)(1) regardless of use in 
          trade or business (temporary).

[[Page 7]]

1.367(a)-6T Transfer of foreign branch with previously deducted losses 
          (temporary).
1.367(a)-8 Gain recognition agreement requirements.
1.367(a)-9T Treatment of deemed section 351 exchanges pursuant to 
          section 304(a)(1) (temporary).
1.367(b)-0 Table of contents.
1.367(b)-1 Other transfers.
1.367(b)-2 Definitions and special rules.
1.367(b)-3 Repatriation of foreign corporate assets in certain 
          nonrecognition transactions.
1.367(b)-3T Repatriation of foreign corporate assets in certain 
          nonrecognition transactions (temporary).
1.367(b)-4 Acquisition of foreign corporate stock or assets by a foreign 
          corporation in certain nonrecognition transactions.
1.367(b)-4T Acquisition of foreign corporate stock or assets by a 
          foreign corporation in certain nonrecognition transactions 
          (temporary).
1.367(b)-5 Distributions of stock described in section 355.
1.367(b)-6 Effective dates and coordination rules.
1.367(b)-7 Carryover of earnings and profits and foreign income taxes in 
          certain foreign-to-foreign nonrecognition transactions.
1.367(b)-8 Allocation of earnings and profits and foreign income taxes 
          in certain foreign corporate separations. [Reserved]
1.367(b)-9 Special rule for F reorganizations and similar transactions.
1.367(b)-12 Subsequent treatment of amounts attributed or included in 
          income.
1.367(b)-13 Special rules for determining basis and holding period.
1.367(b)-14T Acquisition of parent stock for property in triangular 
          reorganizations (temporary).
1.367(d)-1T Transfers of intangible property to foreign corporations 
          (temporary).
1.367(e)-0 Outline of Sec. Sec. 1.367(e)-1 and 1.367(e)-2.
1.367(e)-1 Distributions described in section 367(e)(1).
1.367(e)-2 Distributions described in section 367(e)(2).

                        special rule; definitions

1.368-1 Purpose and scope of exception of reorganization exchanges.
1.368-1T Purpose and scope of exception of reorganization exchanges 
          (temporary).
1.368-2 Definition of terms.
1.368-3 Records to be kept and information to be filed with returns.

                       Insolvency Reorganizations

                               Carryovers

1.381(a)-1 General rule relating to carryovers in certain corporate 
          acquisitions.
1.381(b)-1 Operating rules applicable to carryovers in certain corporate 
          acquisitions.
1.381(c)(1)-1 Net operating loss carryovers in certain corporate 
          acquisitions.
1.381(c)(1)-2 Net operating loss carryovers; two or more dates of 
          distribution or transfer in the taxable year.
1.381(c)(2)-1 Earnings and profits.
1.381(c)(3)-1 Capital loss carryovers.
1.381(c)(4)-1 Method of accounting.
1.381(c)(5)-1 Inventories.
1.381(c)(6)-1 Depreciation method.
1.381(c)(8)-1 Installment method.
1.381(c)(9)-1 Amortization of bond discount or premium.
1.381(c)(10)-1 Deferred exploration and development expenditures.
1.381(c)(11)-1 Contributions to pension plan, employees' annuity plans, 
          and stock bonus and profit-sharing plans.
1.381(c)(12)-1 Recovery of bad debts, prior taxes, or delinquency 
          amounts.
1.381(c)(13)-1 Involuntary conversions.
1.381(c)(14)-1 Dividend carryover to personal holding company.
1.381(c)(15)-1 Indebtedness of certain personal holding companies.
1.381(c)(16)-1 Obligations of distributor or transferor corporation.
1.381(c)(17)-1 Deficiency dividend of personal holding company.
1.381(c)(18)-1 Depletion on extraction of ores or minerals from the 
          waste or residue of prior mining.
1.381(c)(19)-1 Charitable contribution carryovers in certain 
          acquisitions.
1.381(c)(21)-1 Pre-1954 adjustments resulting from change in method of 
          accounting.
1.381(c)(22)-1 Successor life insurance company.
1.381(c)(23)-1 Investment credit carryovers in certain corporate 
          acquisitions.
1.381(c)(24)-1 Work incentive program credit carryovers in certain 
          corporate acquisitions.
1.381(c)(25)-1 Deficiency dividend of a qualified investment entity.
1.381(c)(26)-1 Credit for employment of certain new employees.
1.381(d)-1 Operations loss carryovers of life insurance companies.
1.382-1 Table of contents.
1.382-1T Table of contents (temporary).
1.382-2 General rules for ownership change.
1.382-2T Definition of ownership change under section 382, as amended by 
          the Tax Reform Act of 1986 (temporary).
1.382-3 Definitions and rules relating to a 5-percent shareholder.
1.382-4 Constructive ownership of stock.

[[Page 8]]

1.382-5 Section 382 limitation. [Reserved]
1.382-6 Allocation of income and loss to periods before and after the 
          change date for purposes of section 382.
1.382-7 Built-in gains and losses.
1.382-8 Controlled groups.
1.382-9 Special rules under section 382 for corporations under the 
          jurisdiction of a court in a title 11 or similar case.
1.382-10 Special rules for determining time and manner of acquisition of 
          an interest in a loss corporation.
1.382-11 Reporting requirements.
1.383-0 Effective date.
1.383-1 Special limitations on certain capital losses and excess 
          credits.
1.383-2 Limitations on certain capital losses and excess credits in 
          computing alternative minimum tax. [Reserved]

    Authority: 26 U.S.C. 7805, unless otherwise noted.
    Section 1.301-1 also issued under 26 U.S.C. 357(d)(3).
    Section 1.301-1T also issued under 26 U.S.C. 357(d)(3).
    Section 1.304-5 also issued under 26 U.S.C. 304.
    Section 1.305-3 also issued under 26 U.S.C. 305.
    Section 1.305-5 also issued under 26 U.S.C. 305.
    Section 1.305-7 also issued under 26 U.S.C. 305.
    Section 1.337(d)-1 also issued under 26 U.S.C. 337(d).
    Section 1.337(d)-2 also issued under 26 U.S.C. 337(d).
    Section 1.337(d)-4 also issued under 26 U.S.C. 337.
    Section 1.337(d)-5 also issued under 26 U.S.C. 337.
    Section 1.337(d)-6 also issued under 26 U.S.C. 337.
    Section 1.337(d)-7 also issued under 26 U.S.C. 337.
    Section 1.338-1 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-2 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-3 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-4 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-5 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-6 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-7 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-8 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-9 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-10 also issued under 26 U.S.C. 337(d), 338, and 1502.
    Section 1.338-11 also issued under 26 U.S.C. 338.
    Section 1.338-11T also issued under 26 U.S.C. 338.
    Section 1.338(h)(10)-1 also issued under 26 U.S.C. 337(d), 338, and 
1502.
    Section 1.338(h)(10)-1T also issued under 26 U.S.C. 337(d), 338 and 
1502.
    Section 1.338(i)-1 also issued under 26 U.S.C. 337(d), 338, and 
1502.
    Section 1.351-1 also issued under 26 U.S.C. 351.
    Section 1.351-2 also issued under 26 U.S.C. 351(g)(4).
    Section 1.354-1 also issued under 26 U.S.C. 351(g)(4).
    Section 1.355-1 also issued under 26 U.S.C. 351(g)(4).
    Section 1.355-2T(g) and (i) are also issued under 26 U.S.C. 
355(b)(3)(D).
    Section 1.355-6 also issued under 26 U.S.C. 355(d)(9).
    Section 1.356-6 also issued under 26 U.S.C. 351(g)(4).
    Section 1.355-7 also issued under 26 U.S.C. 355(e)(5).
    Section 1.356-7 also issued under 26 U.S.C. 351(g)(4).
    Section 1.358-2 also issued under 26 U.S.C. 358.
    Section 1.358-5 also issued under 26 U.S.C. 358(h)(2).
    Section 1.358-5T also issued under 26 U.S.C. 358(h)(2).
    Section 1.358-7 also issued under Public Law 106-554, 114 Stat. 
2763, 2763A-638 (2001).
    Section 1.367(a)-3 also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(a)-3T(b)(2)(i)(C) also issued under 26 U.S.C. 367(a) 
and (b).
    Section 1.367(a)-8 also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(a)-9T also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(b)-1 also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(b)-2 also issued under 26 U.S.C. 367(a) and (b).
    Sections 1.367(b)-2(c)(1) and (2) also issued under 26 U.S.C. 
367(b)(1) and (2).
    Section 1.367(b)-2(d)(3) also issued under 26 U.S.C. 367(b)(1) and 
(2).
    Section 1.367(b)-3 also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(b)-3T also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(b)-4 also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(b)-4(d) also issued under 26 U.S.C. 367(b)(1) and (2).
    Section 1.367(b)-4T also issued under 26 U.S.C. 367(b).
    Section 1.367(b)-7 also issued under 26 U.S.C. 367(a) and (b), 26 
U.S.C. 902, and 26 U.S.C. 904.
    Section 1.367(b)-8 also issued under 26 U.S.C. 367(b).

[[Page 9]]

    Section 1.367(b)-9 also issued under 26 U.S.C. 367(a) and (b), 26 
U.S.C. 902, and 26 U.S.C. 904.
    Section 1.367(b)-12 also issued under 26 U.S.C. 367(a) and (b).
    Section 1.367(b)-13 also issued under 26 U.S.C. 367(b).
    Section 1.367(b)-14T also issued under 26 U.S.C. 367(b).
    Section 1.367(e)-1 also issued under 26 U.S.C. 367(e)(1).
    Section 1.367(e)-2 also issued under 26 U.S.C. 367(e)(2).
    Section 1.382-2 also issued under 26 U.S.C. 382(k)(1), (l)(3), (m), 
and 26 U.S.C. 383.
    Section 1.382-2T also issued under 26 U.S.C. 382(g)(4)(C), (i), 
(k)(1) and (6), (l)(3), (m), and 26 U.S.C. 383.
    Section 1.382-3 also issued under 26 U.S.C. 382(m).
    Section 1.382-4 also issued under 26 U.S.C. 382(l)(3) and 382(m).
    Section 1.382-5 also issued under 26 U.S.C. 382(m).
    Section 1.382-5T also issued under 26 U.S.C. 382(m).
    Section 1.382-6 also issued under 26 U.S.C. 382(b)(3)(A), 26 
U.S.C.(d)(1), 26 U.S.C. 382(m), and 26 U.S.C.383(d).
    Section 1.382-7 also issued under 26 U.S.C 382(m).
    Section 1.382-7T also issued under 26 U.S.C. 382(m).
    Section 1.382-8 also issued under 26 U.S.C. 382(m).
    Section 1.382-9 also issued under 26 U.S.C. 382(l)(3) and (m).
    Section 1.382-10 also issued under 26 U.S.C 382(m).
    Section 1.382-10T is also issued under 26 U.S.C. 382(m).
    Section 1.383-1 also issued under 26 U.S.C. 383.
    Section 1.383-2 also issued under 26 U.S.C. 383.

    Source: T.D. 6500, 25 FR 11607, Nov. 26, 1960; 25 FR 14021, Dec. 31, 
1960, unless otherwise noted.

                 CORPORATE DISTRIBUTIONS AND ADJUSTMENTS

                      DISTRIBUTIONS BY CORPORATIONS

                          Effects on Recipients



Sec. 1.301-1  Rules applicable with respect to distributions of money and other property.

    (a) General. Section 301 provides the general rule for treatment of 
distributions on or after June 22, 1954, of property by a corporation to 
a shareholder with respect to its stock. The term property is defined in 
section 317(a). Such distributions, except as otherwise provided in this 
chapter, shall be treated as provided in section 301(c). Under section 
301(c), distributions may be included in gross income, applied against 
and reduce the adjusted basis of the stock, treated as gain from the 
sale or exchange of property, or (in the case of certain distributions 
out of increase in value accrued before March 1, 1913) may be exempt 
from tax. The amount of the distributions to which section 301 applies 
is determined in accordance with the provisions of section 301(b). The 
basis of property received in a distribution to which section 301 
applies is determined in accordance with the provisions of section 
301(d). Accordingly, except as otherwise provided in this chapter, a 
distribution on or after June 22, 1954, of property by a corporation to 
a shareholder with respect to its stock shall be included in gross 
income to the extent the amount distributed is considered a dividend 
under section 316. For examples of distributions treated otherwise, see 
sections 116, 301(c)(2), 301(c)(3)(B), 301(e), 302(b), 303, and 305. See 
also part II (relating to distributions in partial or complete 
liquidation), part III (relating to corporate organizations and 
reorganizations), and part IV (relating to insolvency reorganizations), 
subchapter C, chapter 1 of the Code.
    (b) Time of inclusion in gross income and of determination of fair 
market value. A distribution made by a corporation to its shareholders 
shall be included in the gross income of the distributees when the cash 
or other property is unqualifiedly made subject to their demands. 
However, if such distribution is a distribution other than in cash, the 
fair market value of the property shall be determined as of the date of 
distribution without regard to whether such date is the same as that on 
which the distribution is includible in gross income. For example, if a 
corporation distributes a taxable dividend in property (the adjusted 
basis of which exceeds its fair market value on December 31, 1955) on 
December 31, 1955, which is received by, or unqualifiedly made subject 
to the demand of, its shareholders on January 2, 1956, the amount to be 
included in the gross income of

[[Page 10]]

the shareholders will be the fair market value of such property on 
December 31, 1955, although such amount will not be includible in the 
gross income of the shareholders until January 2, 1956.
    (c) Application of section to shareholders. Section 301 is not 
applicable to an amount paid by a corporation to a shareholder unless 
the amount is paid to the shareholder in his capacity as such.
    (d) Distributions to corporate shareholders. (1) If the shareholder 
is a corporation, the amount of any distribution to be taken into 
account under section 301(c) shall be:
    (i) The amount of money distributed,
    (ii) An amount equal to the fair market value of any property 
distributed which consists of any obligations of the distributing 
corporation, stock of the distributing corporation treated as property 
under section 305(b), or rights to acquire such stock treated as 
property under section 305(b), plus
    (iii) In the case of a distribution not described in subdivision 
(iv) of this subparagraph, an amount equal to (a) the fair market value 
of any other property distributed or, if lesser, (b) the adjusted basis 
of such other property in the hands of the distributing corporation 
(determined immediately before the distribution and increased for any 
gain recognized to the distributing corporation under section 311 (b), 
(c), or (d), or under section 341(f), 617(d), 1245(a), 1250(a), 1251(c), 
1252(a), or 1254(a)), or
    (iv) In the case of a distribution made after November 8, 1971, to a 
shareholder which is a foreign corporation, an amount equal to the fair 
market value of any other property distributed, but only if the 
distribution received by such shareholder is not effectively connected 
for the taxable year with the conduct of a trade or business in the 
United States by such shareholder.
    (2) In the case of a distribution the amount of which is determined 
by reference to the adjusted basis described in subparagraph (1)(iii)(b) 
of this paragraph:
    (i) That portion of the distribution which is a dividend under 
section 301(c)(1) may not exceed such adjusted basis, or
    (ii) If the distribution is not out of earnings and profits, the 
amount of the reduction in basis of the shareholder's stock, and the 
amount of any gain resulting from such distribution, are to be 
determined by reference to such adjusted basis of the property which is 
distributed.
    (3) Notwithstanding paragraph (d)(1)(iii), if a distribution of 
property described in such paragraph is made after December 31, 1962, by 
a foreign corporation to a shareholder which is a corporation, the 
amount of the distribution to be taken into account under section 301(c) 
shall be determined under section 301(b)(1)(C) and paragraph (n) of this 
section.
    (e) Adjusted basis. In determining the adjusted basis of property 
distributed in the hands of the distributing corporation immediately 
before the distribution for purposes of section 301(b)(1)(B)(ii), 
(b)(1)(C)(i), and (d)(2)(B), the basis to be used shall be the basis for 
determining gain upon a sale or exchange.
    (f) Examples. The application of this section (except paragraph (n)) 
may be illustrated by the following examples:

    Example 1. On January 1, 1955, A, an individual owned all of the 
stock of Corporation M with an adjusted basis of $2,000. During 1955, A 
received distributions from Corporation M totaling $30,000, consisting 
of $10,000 in cash and listed securities having a basis in the hands of 
Corporation M and a fair market value on the date distributed of 
$20,000. Corporation M's taxable year is the calendar year. As of 
December 31, 1954, Corporation M had earnings and profits accumulated 
after February 28, 1913, in the amount of $26,000, and it had no 
earnings and profits and no deficit for 1955. Of the $30,000 received by 
A, $26,000 will be treated as an ordinary dividend; the remaining $4,000 
will be applied against the adjusted basis of his stock; the $2,000 in 
excess of the adjusted basis of his stock will either be treated as gain 
from the sale or exchange of property (under section 301(c)(3)(A)) or, 
if out of increase in value accrued before March 1, 1913, will (under 
section 301(c)(3)(B)) be exempt from tax. If A subsequently sells his 
stock in Corporation M, the basis for determining gain or loss on the 
sale will be zero.
    Example 2. The facts are the same as in Example 1 with the 
exceptions that the shareholder of Corporation M is Corporation W and 
that the securities which were distributed had an adjusted basis to 
Corporation M

[[Page 11]]

of $15,000. The distribution received by Corporation W totals $25,000 
consisting of $10,000 in cash and securities with an adjusted basis of 
$15,000. The total $25,000 will be treated as a dividend to Corporation 
W since the earnings and profits of Corporation M ($26,000) are in 
excess of the amount of the distribution.
    Example 3. Corporation X owns timber land which it acquired prior to 
March 1, 1913, at a cost of $50,000 with $5,000 allocated as the 
separate cost of the land. On March 1, 1913, this property had a fair 
market value of $150,000 of which $135,000 was attributable to the 
timber and $15,000 to the land. All of the timber was cut prior to 1955 
and the full appreciation in the value thereof, $90,000 ($135,000-
$45,000), realized through depletion allowances based on March 1, 1913, 
value. None of this surplus from realized appreciation had been 
distributed. In 1955, Corporation X sold the land for $20,000 thereby 
realizing a gain of $15,000. Of this gain, $10,000 is due to realized 
appreciation in value which accrued before March 1, 1913 ($15,000-
$5,000). Of the gain of $15,000, $5,000 is taxable. Therefore, at 
December 31, 1955, Corporation X had a surplus from realized 
appreciation in the amount of $100,000. It had no accumulated earnings 
and profits and no deficit at January 1, 1955. The net earnings for 1955 
(including the $5,000 gain on the sale of the land) were $20,000. During 
1955, Corporation X distributed $75,000 to its stockholders. Of this 
amount, $20,000 will be treated as a dividend. The remaining $55,000, 
which is a distribution of realized appreciation, will be applied 
against and reduce the adjusted basis of the shareholders' stock. If any 
part of the $55,000 is in excess of the adjusted basis of a 
shareholder's stock, such part will be exempt from tax.

    (g) Reduction for liabilities--(1) General rule. For the purpose of 
section 301, no reduction shall be made for the amount of any liability, 
unless the liability is assumed by the shareholder within the meaning of 
section 357(d).
    (2) No reduction below zero. Any reduction pursuant to paragraph 
(g)(1) of this section shall not cause the amount of the distribution to 
be reduced below zero.
    (3) Effective dates--(i) In general. This paragraph (g) applies to 
distributions occurring after January 4, 2001.
    (ii) Retroactive application. This paragraph (g) also applies to 
distributions made on or before January 4, 2001, if the distribution is 
made as part of a transaction described in, or substantially similar to, 
the transaction in Notice 99-59 (1999-2 C.B. 761), including 
transactions designed to reduce gain (see Sec. 601.601(d)(2) of this 
chapter). For rules for distributions on or before January 4, 2001 
(other than distributions on or before that date to which this paragraph 
(g) applies), see rules in effect on January 4, 2001 (see Sec. 1.301-
1(g) as contained in 26 CFR part 1 revised April 1, 2001).
    (h) Basis. The basis of property received in the distribution to 
which section 301 applies shall be--
    (1) If the shareholder is not a corporation, the fair market value 
of such property;
    (2) If the shareholder is a corporation--
    (i) In the case of a distribution of the obligations of the 
distributing corporation or of the stock of such corporation or rights 
to acquire such stock (if such stock or rights are treated as property 
under section 305(b)), the fair market value of such obligations, stock, 
or rights;
    (ii) In the case of the distribution of any other property, except 
as provided in subdivision (iii) (relating to certain distributions by a 
foreign corporation) or subdivision (iv) (relating to certain 
distributions to foreign corporate distributees) of this subparagraph, 
whichever of the following is the lesser--
    (a) The fair market value of such property; or
    (b) The adjusted basis (in the hands of the distributing corporation 
immediately before the distribution) of such property increased in the 
amount of gain to the distributing corporation which is recognized under 
section 311(b) (relating to distributions of LIFO inventory), section 
311(c) (relating to distributions of property subject to liabilities in 
excess of basis), section 311(d) (relating to appreciated proterty used 
to redeem stock), section 341(f) (relating to certain sales of stock of 
consenting corporations), section 617(d) (relating to gain from 
dispositions of certain mining property), section 1245(a) or 1250(a) 
(relating to gain from dispositions of certain depreciable property), 
section 1251(c) (relating to gain from disposition of farm recapture 
property), section 1252(a) (relating to gain from disposition of farm 
land), or

[[Page 12]]

1254(a) (relating to gain from disposition of interest in natural 
resource recapture property);
    (iii) In the case of the distribution by a foreign corporation of 
any other property after December 31, 1962, in a distribution not 
described in subdivision (iv) of this subparagraph, the amount 
determined under paragraph (n) of this section;
    (iv) In the case of the distribution of any other property made 
after November 8, 1971, to a shareholder which is a foreign corporation, 
the fair market value of such property, but only if the distribution 
received by such shareholder is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by such shareholder.
    (i) [Reserved]
    (j) Transfers for less than fair market value. If property is 
transferred by a corporation to a shareholder which is not a corporation 
for an amount less than its fair market value in a sale or exchange, 
such shareholder shall be treated as having received a distribution to 
which section 301 applies. In such case, the amount of the distribution 
shall be the difference between the amount paid for the property and its 
fair market value. If property is transferred in a sale or exchange by a 
corporation to a shareholder which is a corporation, for an amount less 
than its fair market value and also less than its adjusted basis, such 
shareholder shall be treated as having received a distribution to which 
section 301 applies, and--
    (1) Where the fair market value of the property equals or exceeds 
its adjusted basis in the hands of the distributing corporation the 
amount of the distribution shall be the excess of the adjusted basis 
(increased by the amount of gain recognized under section 311 (b), (c), 
or (d), or under section 341(f), 617(d), 1245(a), 1250(a), 1251(c), 
1252(a), or 1254(a) to the distributing corporation) over the amount 
paid for the property;
    (2) Where the fair market value of the property is less than its 
adjusted basis in the hands of the distributing corporation, the amount 
of the distribution shall be the excess of such fair market value over 
the amount paid for the property. If property is transferred in a sale 
or exchange after December 31, 1962, by a foreign corporation to a 
shareholder which is a corporation for an amount less than the amount 
which would have been computed under paragraph (n) of this section if 
such property had been received in a distribution to which section 301 
applied, such shareholder shall be treated as having received a 
distribution to which section 301 applies, and the amount of the 
distribution shall be the excess of the amount which would have been 
computed under paragraph (n) of this section with respect to such 
property over the amount paid for the property. In all cases, the 
earnings and profits of the distributing corporation shall be decreased 
by the excess of the basis of the property in the hands of the 
distributing corporation over the amount received therefor. In computing 
gain or loss from the subsequent sale of such property, its basis shall 
be the amount paid for the property increased by the amount of the 
distribution.

If property is transferred in a sale or exchange after December 31, 
1962, by a foreign corporation to a shareholder which is a corporation 
for an amount less than the amount which would have been computed under 
paragraph (n) of this section if such property had been received in a 
distribution to which section 301 applied, such shareholder shall be 
treated as having received a distribution to which section 301 applies, 
and the amount of the distribution shall be the excess of the amount 
which would have been computed under paragraph (n) of this section with 
respect to such property over the amount paid for the property. 
Notwithstanding the preceding provisions of this paragraph, if property 
is transferred in a sale or exchange after November 8, 1971, by a 
corporation to a shareholder which is a foreign corporation, for an 
amount less than its fair market value, and if paragraph (d)(1)(iv) of 
this section would apply if such property were received in a 
distribution to which section 301 applies, such shareholder shall be 
treated as having received a distribution to which section 301 applies 
and the amount of the distribution shall be the difference between the

[[Page 13]]

amount paid for the property and its fair market value. In all cases, 
the earnings and profits of the distributing corporation shall be 
decreased by the excess of the basis of the property in the hands of the 
distributing corporation over the amount received therefor. In computing 
gain or loss from the subsequent sale of such property, its basis shall 
be the amount paid for the property increased by the amount of the 
distribution.
    (k) Application of rule respecting transfers for less than fair 
market value. The application of paragraph (j) of this section may be 
illustrated by the following examples:

    Example 1. On January 1, 1955, A, an individual shareholder of 
corporation X, purchased property from that corporation for $20. The 
fair market value of such property was $100, and its basis in the hands 
of corporation X was $25. The amount of the distribution determined 
under section 301(b) is $80. If A were a corporation, the amount of the 
distribution would be $5 (assuming that sections 311 (b) and (c), 
1245(a), and 1250(a) do not apply), the excess of the basis of the 
property in the hands of corporation X over the amount received 
therefor. The basis of such property to corporation A would be $25. If 
the basis of the property in the hands of corporation X were $10, the 
corporate shareholder, A, would not receive a distribution. The basis of 
such property to corporation A would be $20. Whether or not A is a 
corporation, the excess of the amount paid over the basis of the 
property in the hands of corporation X ($20 over $10) would be a taxable 
gain to corporation X.
    Example 2. On January 1, 1963, corporation A, which is a shareholder 
of corporation B (a foreign corporation engaged in business within the 
United States), purchased one share of corporation X stock from B for 
$20. The fair market value of the share was $100, and its adjusted basis 
in the hands of B was $25. Assume that if the share of corporation X 
stock had been received by A in a distribution to which section 301 
applied, the amount of the distribution under paragraph (n) of this 
section would have been $55. The amount of the distribution under 
section 301 is $35, i.e., $55 (amount computed under paragraph (n) of 
this section) minus $20 (amount paid for the property). The basis of 
such property to A is $55.

    (l) Transactions treated as distributions. A distribution to 
shareholders with respect to their stock is within the terms of section 
301 although it takes place at the same time as another transaction if 
the distribution is in substance a separate transaction whether or not 
connected in a formal sense. This is most likely to occur in the case of 
a recapitalization, a reincorporation, or a merger of a corporation with 
a newly organized corporation having substantially no property. For 
example, if a corporation having only common stock outstanding, 
exchanges one share of newly issued common stock and one bond in the 
principal amount of $10 for each share of outstanding common stock, the 
distribution of the bonds will be a distribution of property (to the 
extent of their fair market value) to which section 301 applies, even 
though the exchange of common stock for common stock may be pursuant to 
a plan of reorganization under the terms of section 368(a)(1)(E) 
(recapitalization) and even though the exchange of common stock for 
common stock may be tax free by virtue of section 354.
    (m) Cancellation of indebtedness. The cancellation of indebtedness 
of a shareholder by a corporation shall be treated as a distribution of 
property.
    (n) [Reserved]
    (o) Distributions of certain property by DISC's to corporate 
shareholders. See Sec. 1.997-1 for the rule that if a corporation which 
is a DISC or former DISC (as defined in section 992(a)(1) or (3) as the 
case may be) makes a distribution of property (other than money and 
other than the obligations of the DISC or former DISC) out of 
accumulated DISC income (as defined in section 996(f)(1)) or previously 
taxed income (as defined in section 996(f)(2)), such distribution of 
property shall be treated as if it were made to an individual and that 
the basis of the property distributed, in the hands of the recipient 
corporation, shall be determined as if such property were distributed to 
an individual.
    (p) Cross references. For certain rules relating to adjustments to 
earnings and profits and for determining the extent to which a 
distribution is a dividend, see sections 312 and 316 and regulations 
thereunder.
    (q) Split-dollar and other life insurance arrangements--(1) Split-
dollar life insurance arrangements--(i) Distribution of economic 
benefits. The provision by a corporation to its shareholder pursuant

[[Page 14]]

to a split-dollar life insurance arrangement, as defined in Sec. 1.61-
22(b)(1) or (2), of economic benefits described in Sec. 1.61-22(d) or 
of amounts described in Sec. 1.61-22(e) is treated as a distribution of 
property, the amount of which is determined under Sec. 1.61-22(d) and 
(e), respectively.
    (ii) Distribution of entire contract or undivided interest therein. 
A transfer (within the meaning of Sec. 1.61-22(c)(3)) of the ownership 
of a life insurance contract (or an undivided interest therein) that is 
part of a split-dollar life insurance arrangement is a distribution of 
property, the amount of which is determined pursuant to Sec. 1.61-
22(g)(1) and (2).
    (2) Other life insurance arrangements. A payment by a corporation on 
behalf of a shareholder of premiums on a life insurance contract or an 
undivided interest therein that is owned by the shareholder constitutes 
a distribution of property, even if such payment is not part of a split-
dollar life insurance arrangement under Sec. 1.61-22(b).
    (3) When distribution is made--(i) In general. Except as provided in 
paragraph (q)(3)(ii) of this section, paragraph (b) of this section 
shall apply to determine when a distribution described in paragraph 
(q)(1) or (2) of this section is taken into account by a shareholder.
    (ii) Exception. Notwithstanding paragraph (b) of this section, a 
distribution described in paragraph (q)(1)(ii) of this section shall be 
treated as made by a corporation to its shareholder at the time that the 
life insurance contract, or an undivided interest therein, is 
transferred (within the meaning of Sec. 1.61-22(c)(3)) to the 
shareholder.
    (4) Effective date--(i) General rule. This paragraph (q) applies to 
split-dollar and other life insurance arrangements entered into after 
September 17, 2003. For purposes of this paragraph (q)(4), a split-
dollar life insurance arrangement is entered into as determined under 
Sec. 1.61-22(j)(1)(ii).
    (ii) Modified arrangements treated as new arrangements. If a split-
dollar life insurance arrangement entered into on or before September 
17, 2003 is materially modified (within the meaning of Sec. 1.61-
22(j)(2)) after September 17, 2003, the arrangement is treated as a new 
arrangement entered into on the date of the modification.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting Sec. 
1.301-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.fdsys.gov.



Sec. 1.302-1  General.

    (a) Under section 302(d), unless otherwise provided in subchapter C, 
chapter 1 of the Code, a distribution in redemption of stock shall be 
treated as a distribution of property to which section 301 applies if 
the distribution is not within any of the provisions of section 302(b). 
A distribution in redemption of stock shall be considered a distribution 
in part or full payment in exchange for the stock under section 302(a) 
provided paragraph (1), (2), (3), or (4) of section 302(b) applies. 
Section 318(a) (relating to constructive ownership of stock) applies to 
all redemptions under section 302 except that in the termination of a 
shareholder's interest certain limitations are placed on the application 
of section 318(a)(1) by section 302(c)(2). The term redemption of stock 
is defined in section 317(b). Section 302 does not apply to that portion 
of any distribution which qualifies as a distribution in partial 
liquidation under section 346. For special rules relating to redemption 
of stock to pay death taxes see section 303. For special rules relating 
to redemption of section 306 stock see section 306. For special rules 
relating to redemption of stock in partial or complete liquidation see 
section 331.
    (b) If, in connection with a partial liquidation under the terms of 
section 346, stock is redeemed in an amount in excess of the amount 
specified by section 331(a)(2), section 302(b) shall first apply as to 
each shareholder to which it is applicable without limitation because of 
section 331(a)(2). That portion of the total distribution which is used 
in all redemptions from specific shareholders which are within the terms 
of section 302(a) shall be excluded in determining the application of 
sections 346 and 331(a)(2). For example, Corporation X has $50,000 which 
is attributable to the sale of one of two active businesses and which, 
if distributed in redemption of stock, would qualify as a

[[Page 15]]

partial liquidation under the terms of section 346(b). Corporation X 
distributes $60,000 to its shareholders in redemption of stock, $20,000 
of which is in redemption of all of the stock of shareholder A within 
the meaning of section 302(b)(3). The $20,000 distributed in redemption 
of the stock of shareholder A will be excluded in determining the 
application of sections 346 and 331(a)(2). The entire $60,000 will be 
treated as in part or full payment for stock ($20,000 qualifying under 
section 302(a) and $40,000 qualifying under sections 346 and 331(a)(2)).



Sec. 1.302-2  Redemptions not taxable as dividends.

    (a) In general. The fact that a redemption fails to meet the 
requirements of paragraph (2), (3) or (4) of section 302(b) shall not be 
taken into account in determining whether the redemption is not 
essentially equivalent to a dividend under section 302(b)(1). See, 
however, paragraph (b) of this section. For example, if a shareholder 
owns only nonvoting stock of a corporation which is not section 306 
stock and which is limited and preferred as to dividends and in 
liquidation, and one-half of such stock is redeemed, the distribution 
will ordinarily meet the requirements of paragraph (1) of section 302(b) 
but will not meet the requirements of paragraph (2), (3) or (4) of such 
section. The determination of whether or not a distribution is within 
the phrase ``essentially equivalent to a dividend'' (that is, having the 
same effect as a distribution without any redemption of stock) shall be 
made without regard to the earnings and profits of the corporation at 
the time of the distribution. For example, if A owns all the stock of a 
corporation and the corporation redeems part of his stock at a time when 
it has no earnings and profits, the distribution shall be treated as a 
distribution under section 301 pursuant to section 302(d).
    (b) Redemption not essentially equivalent to a dividend--(1) In 
general. The question whether a distribution in redemption of stock of a 
shareholder is not essentially equivalent to a dividend under section 
302(b)(1) depends upon the facts and circumstances of each case. One of 
the facts to be considered in making this determination is the 
constructive stock ownership of such shareholder under section 318(a). 
All distributions in pro rata redemptions of a part of the stock of a 
corporation generally will be treated as distributions under section 301 
if the corporation has only one class of stock outstanding. However, for 
distributions in partial liquidation, see section 302(e). The redemption 
of all of one class of stock (except section 306 stock) either at one 
time or in a series of redemptions generally will be considered as a 
distribution under section 301 if all classes of stock outstanding at 
the time of the redemption are held in the same proportion. 
Distributions in redemption of stock may be treated as distributions 
under section 301 regardless of the provisions of the stock certificate 
and regardless of whether all stock being redeemed was acquired by the 
stockholders from whom the stock was redeemed by purchase or otherwise.
    (2) Statement. Unless Sec. 1.331-1(d) applies, every significant 
holder that transfers stock to the issuing corporation in exchange for 
property from such corporation must include on or with such holder's 
return for the taxable year of such exchange a statement entitled, 
``STATEMENT PURSUANT TO Sec. 1.302-2(b)(2) BY [INSERT NAME AND TAXPAYER 
IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A SIGNIFICANT HOLDER OF THE 
STOCK OF [INSERT NAME AND EMPLOYER IDENTIFICATION NUMBER (IF ANY) OF 
ISSUING CORPORATION].'' If a significant holder is a controlled foreign 
corporation (within the meaning of section 957), each United States 
shareholder (within the meaning of section 951(b)) with respect thereto 
must include this statement on or with its return. The statement must 
include--
    (i) The fair market value and basis of the stock transferred by the 
significant holder to the issuing corporation; and
    (ii) A description of the property received by the significant 
holder from the issuing corporation.
    (3) Definitions. For purposes of this section:

[[Page 16]]

    (i) Significant holder means any person that, immediately before the 
exchange--
    (A) Owned at least five percent (by vote or value) of the total 
outstanding stock of the issuing corporation if the stock owned by such 
person is publicly traded; or
    (B) Owned at least one percent (by vote or value) of the total 
outstanding stock of the issuing corporation if the stock owned by such 
person is not publicly traded.
    (ii) Publicly traded stock means stock that is listed on--
    (A) A national securities exchange registered under section 6 of the 
Securities Exchange Act of 1934 (15 U.S.C. 78f); or
    (B) An interdealer quotation system sponsored by a national 
securities association registered under section 15A of the Securities 
Exchange Act of 1934 (15 U.S.C. 78o-3).
    (iii) Issuing corporation means the corporation that issued the 
shares of stock, some or all of which were transferred by a significant 
holder to such corporation in the exchange described in paragraph (b)(2) 
of this section.
    (4) Cross reference. See section 6043 of the Internal Revenue Code 
for requirements relating to a return by a liquidating corporation.
    (c) Basis adjustments. In any case in which an amount received in 
redemption of stock is treated as a distribution of a dividend, proper 
adjustment of the basis of the remaining stock will be made with respect 
to the stock redeemed. (For adjustments to basis required for certain 
redemptions of corporate shareholders that are treated as extraordinary 
dividends, see section 1059 and the regulations thereunder.) The 
following examples illustrate the application of this rule:

    Example 1. A, an individual, purchased all of the stock of 
Corporation X for $100,000. In 1955 the corporation redeems half of the 
stock for $150,000, and it is determined that this amount constitutes a 
dividend. The remaining stock of Corporation X held by A has a basis of 
$100,000.
    Example 2. H and W, husband and wife, each own half of the stock of 
Corporation X. All of the stock was purchased by H for $100,000 cash. In 
1950 H gave one-half of the stock to W, the stock transferred having a 
value in excess of $50,000. In 1955 all of the stock of H is redeemed 
for $150,000, and it is determined that the distribution to H in 
redemption of his shares constitutes the distribution of a dividend. 
Immediately after the transaction, W holds the remaining stock of 
Corporation X with a basis of $100,000.
    Example 3. The facts are the same as in Example (2) with the 
additional facts that the outstanding stock of Corporation X consists of 
1,000 shares and all but 10 shares of the stock of H is redeemed. 
Immediately after the transaction, H holds 10 shares of the stock of 
Corporation X with a basis of $50,000, and W holds 500 shares with a 
basis of $50,000.
    (d) Effective/applicability date. Paragraphs (b)(2), (b)(3) and 
(b)(4) of this section apply to any taxable year beginning on or after 
May 30, 2006. However, taxpayers may apply paragraphs (b)(2), (b)(3) and 
(b)(4) of this section to any original Federal income tax return 
(including any amended return filed on or before the due date (including 
extensions) of such original return) timely filed on or after May 30, 
2006. For taxable years beginning before May 30, 2006, see Sec. 1.302-2 
as contained in 26 CFR part 1 in effect on April 1, 2006.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 8724, 62 FR 
38028, July 26, 1997; T.D. 9264, 71 FR 30593, May 30, 2006; T.D. 9329, 
72 FR 32796, June 14, 2007]



Sec. 1.302-3  Substantially disproportionate redemption.

    (a) Section 302(b)(2) provides for the treatment of an amount 
received in redemption of stock as an amount received in exchange for 
such stock if--
    (1) Immediately after the redemption the shareholder owns less than 
50 percent of the total combined voting power of all classes of stock as 
provided in section 302(b)(2)(B),
    (2) The redemption is a substantially disproportionate redemption 
within the meaning of section 302(b)(2)(C), and
    (3) The redemption is not pursuant to a plan described in section 
302(b)(2)(D).

Section 318(a) (relating to constructive ownership of stock) shall apply 
both in making the disproportionate redemption test and in determining 
the percentage of stock ownership after the redemption. The requirements 
under section 302(b)(2) shall be applied to each shareholder separately 
and shall be applied only with respect to stock which is issued and 
outstanding in the hands of the shareholders. Section

[[Page 17]]

302(b)(2) only applies to a redemption of voting stock or to a 
redemption of both voting stock and other stock. Section 302(b)(2) does 
not apply to the redemption solely of nonvoting stock (common or 
preferred). However, if a redemption is treated as an exchange to a 
particular shareholder under the terms of section 302(b)(2), such 
section will apply to the simultaneous redemption of nonvoting preferred 
stock (which is not section 306 stock) owned by such shareholder and 
such redemption will also be treated as an exchange. Generally, for 
purposes of this section, stock which does not have voting rights until 
the happening of an event, such as a default in the payment of dividends 
on preferred stock, is not voting stock until the happening of the 
specified event. Subsection 302(b)(2)(D) provides that a redemption will 
not be treated as substantially disproportionate if made pursuant to a 
plan the purpose or effect of which is a series of redemptions which 
result in the aggregate in a distribution which is not substantially 
disproportionate. Whether or not such a plan exists will be determined 
from all the facts and circumstances.
    (b) The application of paragraph (a) of this section is illustrated 
by the following example:

    Example. Corporation M has outstanding 400 shares of common stock of 
which A, B, C and D each own 100 shares or 25 percent. No stock is 
considered constructively owned by A, B, C or D under section 318. 
Corporation M redeems 55 shares from A, 25 shares from B, and 20 shares 
from C. For the redemption to be disproportionate as to any shareholder, 
such shareholder must own after the redemptions less than 20 percent (80 
percent of 25 percent) of the 300 shares of stock then outstanding. 
After the redemptions, A owns 45 shares (15 percent), B owns 75 shares 
(25 percent), and C owns 80 shares (26 2/3 percent). The distribution is 
disproportionate only with respect to A.



Sec. 1.302-4  Termination of shareholder's interest.

    Section 302(b)(3) provides that a distribution in redemption of all 
of the stock of the corporation owned by a shareholder shall be treated 
as a distribution in part or full payment in exchange for the stock of 
such shareholder. In determining whether all of the stock of the 
shareholder has been redeemed, the general rule of section 302(c)(1) 
requires that the rules of constructive ownership provided in section 
318(a) shall apply. Section 302(c)(2), however, provides that section 
318(a)(1) (relating to constructive ownership of stock owned by members 
of a family) shall not apply where the specific requirements of section 
302(c)(2) are met. The following rules shall be applicable in 
determining whether the specific requirements of section 302(c)(2) are 
met:
    (a) Statement. The agreement specified in section 302(c)(2)(A)(iii) 
shall be in the form of a statement entitled, ``STATEMENT PURSUANT TO 
SECTION 302(c)(2)(A)(iii) BY [INSERT NAME AND TAXPAYER IDENTIFICATION 
NUMBER (IF ANY) OF TAXPAYER OR RELATED PERSON, AS THE CASE MAY BE], A 
DISTRIBUTEE (OR RELATED PERSON) OF [INSERT NAME AND EMPLOYER 
IDENTIFICATION NUMBER (IF ANY) OF DISTRIBUTING CORPORATION].'' The 
distributee must include such statement on or with the distributee's 
first return for the taxable year in which the distribution described in 
section 302(b)(3) occurs. If the distributee is a controlled foreign 
corporation (within the meaning of section 957), each United States 
shareholder (within the meaning of section 951(b)) with respect thereto 
must include this statement on or with its return. The distributee must 
represent in the statement--
    (1) THE DISTRIBUTEE (OR RELATED PERSON) HAS NOT ACQUIRED, OTHER THAN 
BY BEQUEST OR INHERITANCE, ANY INTEREST IN THE CORPORATION (AS DESCRIBED 
IN SECTION 302(c)(2)(A)(i)) SINCE THE DISTRIBUTION; and
    (2) THE DISTRIBUTEE (OR RELATED PERSON) WILL NOTIFY THE INTERNAL 
REVENUE SERVICE OF ANY ACQUISITION, OTHER THAN BY BEQUEST OR 
INHERITANCE, OF SUCH AN INTEREST IN THE CORPORATION WITHIN 30 DAYS AFTER 
THE ACQUISITION, IF THE ACQUISITION OCCURS WITHIN 10 YEARS FROM THE DATE 
OF THE DISTRIBUTION.
    (b) Substantiation information. The distributee who files an 
agreement

[[Page 18]]

under section 302(c)(2)(A)(iii) shall retain copies of income tax 
returns and any other records indicating fully the amount of tax which 
would have been payable had the redemption been treated as a 
distribution subject to section 301.
    (c) Stock of parent, subsidiary or successor corporation redeemed. 
If stock of a parent corporation is redeemed, section 302(c)(2)(A), 
relating to acquisition of an interest in the corporation within 10 
years after termination shall be applied with reference to an interest 
both in the parent corporation and any subsidiary of such parent 
corporation. If stock of a parent corporation is sold to a subsidiary in 
a transaction described in section 304, section 302(c)(2)(A) shall be 
applicable to the acquisition of an interest in such subsidiary 
corporation or in the parent corporation. If stock of a subsidiary 
corporation is redeemed, section 302(c)(2)(A) shall be applied with 
reference to an interest both in such subsidiary corporation and its 
parent. Section 302(c)(2)(A) shall also be applied with respect to an 
interest in a corporation which is a successor corporation to the 
corporation the interest in which has been terminated.
    (d) Redeemed shareholder as creditor. For the purpose of section 
302(c)(2)(A)(i), a person will be considered to be a creditor only if 
the rights of such person with respect to the corporation are not 
greater or broader in scope than necessary for the enforcement of his 
claim. Such claim must not in any sense be proprietary and must not be 
subordinate to the claims of general creditors. An obligation in the 
form of a debt may thus constitute a proprietary interest. For example, 
if under the terms of the instrument the corporation may discharge the 
principal amount of its obligation to a person by payments, the amount 
or certainty of which are dependent upon the earnings of the 
corporation, such a person is not a creditor of the corporation. 
Furthermore, if under the terms of the instrument the rate of purported 
interest is dependent upon earnings, the holder of such instrument may 
not, in some cases, be a creditor.
    (e) Acquisition of assets pursuant to creditor's rights. In the case 
of a distributee to whom section 302(b)(3) is applicable, who is a 
creditor after such transaction, the acquisition of the assets of the 
corporation in the enforcement of the rights of such creditor shall not 
be considered an acquisition of an interest in the corporation for 
purposes of section 302(c)(2) unless stock of the corporation, its 
parent corporation, or, in the case of a redemption of stock of a parent 
corporation, of a subsidiary of such corporation is acquired.
    (f) Constructive ownership rules applicable. In determining whether 
an entire interest in the corporation has been terminated under section 
302(b)(3), under all circumstances paragraphs (2), (3), (4), and (5) of 
section 318(a) (relating to constructive ownership of stock) shall be 
applicable.
    (g) Avoidance of Federal income tax. Section 302(c)(2)(B) provides 
that section 302(c)(2)(A) shall not apply--
    (1) If any portion of the stock redeemed was acquired directly or 
indirectly within the 10-year period ending on the date of the 
distribution by the distributee from a person, the ownership of whose 
stock would (at the time of distribution) be attributable to the 
distributee under section 318(a), or
    (2) If any person owns (at the time of the distribution) stock, the 
ownership of which is attributable to the distributee under section 
318(a), such person acquired any stock in the corporation directly or 
indirectly from the distributee within the 10-year period ending on the 
date of the distribution, and such stock so acquired from the 
distributee is not redeemed in the same transaction,unless the 
acquisition (described in subparagraph (1) of this paragraph) or the 
disposition by the distributee (described in subparagraph (2) of this 
paragraph) did not have as one of its principal purposes the avoidance 
of Federal income tax. A transfer of stock by the transferor, within the 
10-year period ending on the date of the distribution, to a person whose 
stock would be attributable to the transferor shall not be deemed to 
have as one of its principal purposes the avoidance of Federal income 
tax merely because the transferee is in a lower income tax bracket than 
the transferor.
    (h) Effective/applicability date. Paragraph (a) of this section 
applies to any

[[Page 19]]

taxable year beginning on or after May 30, 2006. However, taxpayers may 
apply paragraph (a) of this section to any original Federal income tax 
return (including any amended return filed on or before the due date 
(including extensions) of such original return) timely filed on or after 
May 30, 2006. For taxable years beginning before May 30, 2006, see Sec. 
1.302-4 as contained in 26 CFR part 1 in effect on April 1, 2006.

(Sec. 302(c)(2)(A)(iii) (68A Stat. 87; 26 U.S.C. 302 (c)(2)(A)(iii)))

[T.D. 7535, 43 FR 10686, Mar. 15, 1978, as amended by T.D. 9264, 71 FR 
30594, 30607, May 30, 2006; T.D. 9329, 72 FR 32796, 32808, June 14, 
2007]



Sec. 1.303-1  General.

    Section 303 provides that in certain cases a distribution in 
redemption of stock, the value of which is included in determining the 
value of the gross estate of a decedent, shall be treated as a 
distribution in full payment in exchange for the stock so redeemed.



Sec. 1.303-2  Requirements.

    (a) Section 303 applies only where the distribution is with respect 
to stock of a corporation the value of whose stock in the gross estate 
of the decedent for Federal estate tax purposes is an amount in excess 
of (1) 35 percent of the value of the gross estate of such decedent, or 
(2) 50 percent of the taxable estate of such decedent. For the purposes 
of such 35 percent and 50 percent requirements, stock of two or more 
corporations shall be treated as the stock of a single corporation if 
more than 75 percent in value of the outstanding stock of each such 
corporation is included in determining the value of the decedent's gross 
estate. For the purpose of the 75 percent requirement, stock which, at 
the decedent's death, represents the surviving spouse's interest in 
community property shall be considered as having been included in 
determining the value of the decedent's gross estate.
    (b) For the purpose of section 303(b)(2)(A)(i), the term gross 
estate means the gross estate as computed in accordance with section 
2031 (or, in the case of the estate of a decedent nonresident not a 
citizen of the United States, in accordance with section 2103). For the 
purpose of section 303(b)(2)(A)(ii), the term taxable estate means the 
taxable estate as computed in accordance with section 2051 (or, in the 
case of the estate of a decedent nonresident not a citizen of the United 
States, in accordance with section 2106). In case the value of an estate 
is determined for Federal estate tax purposes under section 2032 
(relating to alternate valuation), then, for purposes of section 
303(b)(2), the value of the gross estate, the taxable estate, and the 
stock shall each be determined on the applicable date prescribed in 
section 2032.
    (c)(1) In determining whether the estate of the decedent is 
comprised of stock of a corporation of sufficient value to satisfy the 
percentage requirements of section 303(b)(2)(A) and section 
303(b)(2)(B), the total value, in the aggregate, of all classes of stock 
of the corporation includible in determining the value of the gross 
estate is taken into account. A distribution under section 303(a) may be 
in redemption of the stock of the corporation includible in determining 
the value of the gross estate, without regard to the class of such 
stock.
    (2) The above may be illustrated by the following example:

    Example. The gross estate of the decedent has a value of $1,000,000, 
the taxable estate is $700,000, and the sum of the death taxes and 
funeral and administration expenses is $275,000. Included in determining 
the gross estate of the decedent is stock of three corporations which, 
for Federal estate tax purposes, is valued as follows:

Corporation A:
  Common stock...............................................   $100,000
  Preferred stock............................................    100,000
Corporation B:
  Common stock...............................................     50,000
  Preferred stock............................................    350,000
Corporation C: Common stock..................................    200,000
 


The stock of Corporation A and Corporation C included in the estate of 
the decedent constitutes all of the outstanding stock of both 
corporations. The stock of Corporation A and the stock of Corporation C, 
treated as the stock of a single corporation under section 303(b)(2)(B), 
has a value in excess of $350,000 (35 percent of the gross estate or 50 
percent of the taxable estate). Likewise, the stock of Corporation B has 
a value in excess of $350,000. The distribution by one or more of the 
above corporations, within the period prescribed in section 303(b)(1), 
of amounts not exceeding, in the aggregate, $275,000, in

[[Page 20]]

redemption of preferred stock or common stock of such corporation or 
corporations, will be treated as in full payment in exchange for the 
stock so redeemed.

    (d) If stock includible in determining the value of the gross estate 
of a decedent is exchanged for new stock, the basis of which is 
determined by reference to the basis of the old stock, the redemption of 
the new stock will be treated the same under section 303 as the 
redemption of the old stock would have been. Thus section 303 shall 
apply with respect to a distribution in redemption of stock received by 
the estate of a decedent (1) in connection with a reorganization under 
section 368, (2) in a distribution or exchange under section 355 (or so 
much of section 356 as relates to section 355), (3) in an exchange under 
section 1036 or (4) in a distribution to which section 305(a) applies. 
Similarly, a distribution in redemption of stock will qualify under 
section 303, notwithstanding the fact that the stock redeemed is section 
306 stock to the extent that the conditions of section 303 are met.
    (e) Section 303 applies to distributions made after the death of the 
decedent and (1) before the expiration of the 3-year period of 
limitations for the assessment of estate tax provided in section 6501(a) 
(determined without the application of any provisions of law extending 
or suspending the running of such period of limitations), or within 90 
days after the expiration of such period, or (2) if a petition for 
redetermination of a deficiency in such estate tax has been filed with 
the Tax Court within the time prescribed in section 6213, at any time 
before the expiration of 60 days after the decision of the Tax Court 
becomes final. The extension of the period of distribution provided in 
section 303(b)(1)(B) has reference solely to bona fide contests in the 
Tax Court and will not apply in the case of a petition for 
redetermination of a deficiency which is initiated solely for the 
purpose of extending the period within which section 303 would otherwise 
be applicable.
    (f) While section 303 will most frequently have application in the 
case where stock is redeemed from the executor or administrator of an 
estate, the section is also applicable to distributions in redemption of 
stock included in the decedent's gross estate and held at the time of 
the redemption by any person who acquired the stock by any of the means 
comprehended by part III, subchapter A, chapter 11 of the Code, 
including the heir, legatee, or donee of the decedent, a surviving joint 
tenant, surviving spouse, appointee, or taker in default of appointment, 
or a trustee of a trust created by the decedent. Thus section 303 may 
apply with respect to a distribution in redemption of stock from a donee 
to whom the decedent has transferred stock in contemplation of death 
where the value of such stock is included in the decedent's gross estate 
under section 2035. Similarly, section 303 may apply to the redemption 
of stock from a beneficiary of the estate to whom an executor has 
distributed the stock pursuant to the terms of the will of the decedent. 
However, section 303 is not applicable to the case where stock is 
redeemed from a stockholder who has acquired the stock by gift or 
purchase from any person to whom such stock has passed from the 
decedent. Nor is section 303 applicable to the case where stock is 
redeemed from a stockholder who has acquired the stock from the executor 
in satisfaction of a specific monetary bequest.
    (g)(1) The total amount of the distributions to which section 303 
may apply with respect to redemptions of stock included in the gross 
estate of a decedent may not exceed the sum of the estate, inheritance, 
legacy, and succession taxes (including any interest collected as a part 
of such taxes) imposed because of the decedent's death and the amount of 
funeral and administration expenses allowable as deductions to the 
estate. Where there is more than one distribution in redemption of stock 
described in section 303(b)(2) during the period of time prescribed in 
section 303(b)(1), the distributions shall be applied against the total 
amount which qualifies for treatment under section 303 in the order in 
which the distributions are made. For this purpose, all distributions in 
redemption of such stock shall be taken into account, including 
distributions which under another provision of the

[[Page 21]]

Code are treated as in part or full payment in exchange for the stock 
redeemed.
    (2) Subparagraph (1) of this paragraph may be illustrated by the 
following example:

    Example. (i) The gross estate of the decedent has a value of 
$800,000, the taxable estate is $500,000, and the sum of the death taxes 
and funeral and administrative expenses is $225,000. Included in 
determining the gross estate of the decedent is the stock of a 
corporation which for Federal estate tax purposes is valued at $450,000. 
During the first year of administration, one-third of such stock is 
distributed to a legatee and shortly thereafter this stock is redeemed 
by the corporation for $150,000. During the second year of 
administration, another one-third of such stock includible in the estate 
is redeemed for $150,000.
    (ii) The first distribution of $150,000 is applied against the 
$225,000 amount that qualifies for treatment under section 303, 
regardless of whether the first distribution was treated as in payment 
in exchange for stock under section 302(a). Thus, only $75,000 of the 
second distribution may be treated as in full payment in exchange for 
stock under section 303. The tax treatment of the remaining $75,000 
would be determined under other provisions of the Code.

    (h) For the purpose of section 303, the estate tax or any other 
estate, inheritance, legacy, or succession tax shall be ascertained 
after the allowance of any credit, relief, discount, refund, remission 
or reduction of tax.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6724, 29 FR 
5343, Apr. 21, 1964; T.D. 7346, 40 FR 10669, Mar. 7, 1975]



Sec. 1.303-3  Application of other sections.

    (a) The sole effect of section 303 is to exempt from tax as a 
dividend a distribution to which such section is applicable when made in 
redemption of stock includible in a decedent's gross estate. Such 
section does not, however, in any other manner affect the principles set 
forth in sections 302 and 306. Thus, if stock of a corporation is owned 
equally by A, B, and the C Estate, and the corporation redeems one-half 
of the stock of each shareholder, the determination of whether the 
distributions to A and B are essentially equivalent to dividends shall 
be made without regard to the effect which section 303 may have upon the 
taxability of the distribution to the C Estate.
    (b) See section 304 relative to redemption of stock through the use 
of related corporations.



Sec. 1.304-1  General.

    (a) Except as provided in paragraph (b) of this section, section 304 
is applicable where a shareholder sells stock of one corporation to a 
related corporation as defined in section 304. Sales to which section 
304 is applicable shall be treated as redemptions subject to sections 
302 and 303.
    (b) In the case of--
    (1) Any acquisition of stock described in section 304 which occurred 
before June 22, 1954, and
    (2) Any acquisition of stock described in section 304 which occurred 
on or after June 22, 1954, and on or before December 31, 1958, pursuant 
to a contract entered into before June 22, 1954.

The extent to which the property received in return for such acquisition 
shall be treated as a dividend shall be determined as if the Internal 
Revenue Code of 1939 continued to apply in respect of such acquisition 
and as if the Internal Revenue Code of 1954 had not been enacted. See 
section 391. In cases to which this paragraph applies, the basis of the 
stock received by the acquiring corporation shall be determined as if 
the Internal Revenue Code of 1939 continued to apply in respect of such 
acquisition and as if the Internal Revenue Code of 1954 had not been 
enacted.

[T.D. 6533, 26 FR 401, Jan. 19, 1961]



Sec. 1.304-2  Acquisition by related corporation (other than subsidiary).

    (a) If a corporation, in return for property, acquires stock of 
another corporation from one or more persons, and the person or persons 
from whom the stock was acquired were in control of both such 
corporations before the acquisition, then such property shall be treated 
as received in redemption of stock of the acquiring corporation. The 
stock received by the acquiring corporation shall be treated as a 
contribution to the capital of such corporation. See section 362(a) for 
determination of the basis of such stock. The transferor's basis for his 
stock in the acquiring corporation shall be increased by the basis of 
the stock surrendered by

[[Page 22]]

him. (But see below in this paragraph for subsequent reductions of basis 
in certain cases.) As to each person transferring stock, the amount 
received shall be treated as a distribution of property under section 
302(d), unless as to such person such amount is to be treated as 
received in exchange for the stock under the terms of section 302(a) or 
section 303. In applying section 302(b), reference shall be had to the 
shareholder's ownership of stock in the issuing corporation and not to 
his ownership of stock in the acquiring corporation (except for purposes 
of applying section 318(a)). In determining control and applying section 
302(b), section 318(a) (relating to the constructive ownership of stock) 
shall be applied without regard to the 50-percent limitation contained 
in section 318(a)(2)(C) and (3)(C). A series of redemptions referred to 
in section 302(b)(2)(D) shall include acquisitions by either of the 
corporations of stock of the other and stock redemptions by both 
corporations. If section 302(d) applies to the surrender of stock by a 
shareholder, his basis for his stock in the acquiring corporation after 
the transaction (increased as stated above in this paragraph) shall not 
be decreased except as provided in section 301. If section 302(d) does 
not apply, the property received shall be treated as received in a 
distribution in payment in exchange for stock of the acquiring 
corporation under section 302(a), which stock has a basis equal to the 
amount by which the shareholder's basis for his stock in the acquiring 
corporation was increased on account of the contribution to capital as 
provided for above in this paragraph. Accordingly, such amount shall be 
applied in reduction of the shareholder's basis for his stock in the 
acquiring corporation. Thus, the basis of each share of the 
shareholder's stock in the acquiring corporation will be the same as the 
basis of such share before the entire transaction. The holding period of 
the stock which is considered to have been redeemed shall be the same as 
the holding period of the stock actually surrendered.
    (b) In any case in which two or more persons, in the aggregate, 
control two corporations, section 304(a)(1) will apply to sales by such 
persons of stock in either corporation to the other (whether or not made 
simultaneously) provided the sales by each of such persons are related 
to each other. The determination of whether the sales are related to 
each other shall be dependent upon the facts and circumstances 
surrounding all of the sales. For this purpose, the fact that the sales 
may occur during a period of one or more years (such as in the case of a 
series of sales by persons who together control each of such 
corporations immediately prior to the first of such sales and 
immediately subsequent to the last of such sales) shall be disregarded, 
provided the other facts and circumstances indicate related 
transactions.
    (c) The application of section 304(a)(1) may be illustrated by the 
following examples:

    Example 1. Corporation X and corporation Y each have outstanding 200 
shares of common stock. One-half of the stock of each corporation is 
owned by an individual, A, and one-half by another individual, B, who is 
unrelated to A. On or after August 31, 1964, A sells 30 shares of 
corporation X stock to corporation Y for $50,000, such stock having an 
adjusted basis of $10,000 to A. After the sale, A is considered as 
owning corporation X stock as follows: (i) 70 shares directly, and (ii) 
15 shares constructively, since by virtue of his 50-percent ownership of 
Y he constructively owns 50 percent of the 30 shares owned directly by 
Y. Since A's percentage of ownership of X's voting stock after the sale 
(85 out of 200 shares, or 42.5%) is not less than 80 percent of his 
percentage of ownership of X's voting stock before the sale (100 out of 
200 shares, or 50%), the transfer is not ``substantially 
disproportionate'' as to him as provided in section 302(b)(2). Under 
these facts, and assuming that section 302(b)(1) is not applicable, the 
entire $50,000 is treated as a dividend to A to the extent of the 
earnings and profits of corporation Y. The basis of the corporation X 
stock to corporation Y is $10,000, its adjusted basis to A. The amount 
of $10,000 is added to the basis of the stock of corporation Y in the 
hands of A.
    Example 2. The facts are the same as in Example (1) except that A 
sells 80 shares of corporation X stock to corporation Y, and the sale 
occurs before August 31, 1964. After the sale, A is considered as owning 
corporation X stock as follows: (i) 20 shares directly, and (ii) 90 
shares indirectly, since by virtue of his 50-percent ownership of Y he 
constructively owns 50 percent of the 80 shares owned directly by Y and 
50 percent of the 100 shares attributed to Y because they are owned by

[[Page 23]]

Y's stockholder, B. Since after the sale A owns a total of more than 50 
percent of the voting power of all of the outstanding stock of X (110 
out of 200 shares, or 55%), the transfer is not ``substantially 
disproportionate'' as to him as provided in section 302(b)(2).
    Example 3. Corporation X and corporation Y each have outstanding 100 
shares of common stock. A, an individual, owns one-half the stock of 
corporation X, and C owns one-half the stock of corporation Y. A, B, and 
C are unrelated. A sells 30 shares of the stock of corporation X to 
corporation Y for $50,000, such stock having an adjusted basis of 
$10,000 to him. After the sale, A is considered as owning 35 shares of 
the stock of corporation X (20 shares directly and 15 constructively 
because one-half of the 30 shares owned by corporation Y are attributed 
to him). Since before the sale he owned 50 percent of the stock of 
corporation X and after the sale he owned directly and constructively 
only 35 percent of such stock, the redemption is substantially 
disproportionate as to him pursuant to the provisions of section 
302(b)(2). He, therefore, realizes a gain of $40,000 ($50,000 minus 
$10,000). If the stock surrendered is a capital asset, such gain is 
long-term or short-term capital gain depending on the period of time 
that such stock was held. The basis to A for the stock of corporation Y 
is not changed as a result of the entire transaction. The basis to 
corporation Y for the stock of corporation X is $50,000, i.e., the basis 
of the transferor ($10,000), increased in the amount of gain recognized 
to the transferor ($40,000) on the transfer.
    Example 4. Corporation X and corporation Y each have outstanding 100 
shares of common stock. H, an individual, W, his wife, S, his son, and 
G, his grandson, each own 25 shares of stock of each corporation. H 
sells all of his 25 shares of stock of corporation X to corporation Y. 
Since both before and after the transaction H owned directly and 
constructively 100 percent of the stock of corporation X, and assuming 
that section 302(b)(1) is not applicable, the amount received by him for 
his stock of corporation X is treated as a dividend to him to the extent 
of the earnings and profits of corporation Y.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6969, 33 FR 
11997, Aug. 23, 1968]



Sec. 1.304-3  Acquisition by a subsidiary.

    (a) If a subsidiary acquires stock of its parent corporation from a 
shareholder of the parent corporation, the acquisition of such stock 
shall be treated as though the parent corporation had redeemed its own 
stock. For the purpose of this section, a corporation is a parent 
corporation if it meets the 50 percent ownership requirements of section 
304(c). The determination whether the amount received shall be treated 
as an amount received in payment in exchange for the stock shall be made 
by applying section 303, or by applying section 302(b) with reference to 
the stock of the issuing parent corporation. If such distribution would 
have been treated as a distribution of property (pursuant to section 
302(d)) under section 301, the entire amount of the selling price of the 
stock shall be treated as a dividend to the seller to the extent of the 
earnings and profits of the parent corporation determined as if the 
distribution had been made to it of the property that the subsidiary 
exchanged for the stock. In such cases, the transferor's basis for his 
remaining stock in the parent corporation will be determined by 
including the amount of the basis of the stock of the parent corporation 
sold to the subsidiary.
    (b) Section 304(a)(2) may be illustrated by the following example:

    Example. Corporation M has outstanding 100 shares of common stock 
which are owned as follows: B, 75 shares, C, son of B, 20 shares, and D, 
daughter of B, 5 shares. Corporation M owns the stock of Corporation X. 
B sells his 75 shares of Corporation M stock to Corporation X. Under 
section 302(b)(3) this is a termination of B's entire interest in 
Corporation M and the full amount received from the sale of his stock 
will be treated as payment in exchange for this stock, provided he 
fulfills the requirements of section 302(c)(2) (relating to an 
acquisition of an interest in the corporations).



Sec. 1.304-4  Special rule for the use of related corporations to avoid 

the application of section 304.

    [Reserved] For further guidance, see Sec. 1.304-4T(a) through (d).

[T.D. 9477, 74 FR 69023, Dec. 30, 2009]



Sec. 1.304-4T  Special rule for the use of related corporations to avoid

the application of section 304 (temporary).

    (a) Scope and purpose. This section applies to determine the amount 
of a property distribution constituting a dividend (and the source 
thereof) under section 304(b)(2), for certain transactions involving 
controlled corporations. The purpose of this section is to

[[Page 24]]

prevent the avoidance of the application of section 304 to a controlled 
corporation.
    (b) Amount and source of dividend. For purposes of determining the 
amount constituting a dividend (and source thereof) under section 
304(b)(2), the following rules shall apply:
    (1) Deemed acquiring corporation. A corporation (deemed acquiring 
corporation) shall be treated as acquiring for property the stock of a 
corporation (issuing corporation) acquired for property by another 
corporation (acquiring corporation) that is controlled by the deemed 
acquiring corporation, if a principal purpose for creating, organizing, 
or funding the acquiring corporation by any means (including, through 
capital contributions or debt) is to avoid the application of section 
304 to the deemed acquiring corporation. See paragraph (c) Example 1 of 
this section for an illustration of this paragraph.
    (2) Deemed issuing corporation. The acquiring corporation shall be 
treated as acquiring for property the stock of a corporation (deemed 
issuing corporation) controlled by the issuing corporation if, in 
connection with the acquisition for property of stock of the issuing 
corporation by the acquiring corporation, the issuing corporation 
acquired stock of the deemed issuing corporation with a principal 
purpose of avoiding the application of section 304 to the deemed issuing 
corporation. See paragraph (c) Example 2 of this section for an 
illustration of this paragraph.
    (c) Examples. The rules of this section are illustrated by the 
following examples:

    Example 1. (i) Facts. P, a domestic corporation, wholly owns CFC1, a 
controlled foreign corporation with substantial accumulated earnings and 
profits. CFC1 is organized in Country X, which imposes a high rate of 
tax on the income of CFC1. P also wholly owns CFC2, a controlled foreign 
corporation with accumulated earnings and profits of $200x. CFC2 is 
organized in Country Y, which imposes a low rate of tax on the income of 
CFC2. P wishes to own all of its foreign corporations in a direct chain 
and to repatriate the cash of CFC2. In order to avoid having to obtain 
Country X approval for the acquisition of CFC1 (a Country X corporation) 
by CFC2 (a Country Y corporation) and to avoid the dividend distribution 
from CFC2 to P that would result if CFC2 were the acquiring corporation, 
P causes CFC2 to form CFC3 in Country X and to contribute $100x to CFC3. 
CFC3 then acquires all of the stock of CFC1 from P for $100x.
    (ii) Result. Because a principal purpose for creating, organizing or 
funding CFC3 (acquiring corporation) is to avoid the application of 
section 304 to CFC2 (deemed acquiring corporation), under paragraph 
(b)(1) of this section, for purposes of determining the amount of the 
$100x distribution constituting a dividend (and source thereof) under 
section 304(b)(2), CFC2 shall be treated as acquiring the stock of CFC1 
(issuing corporation) from P for $100x. As a result, P receives a $100x 
distribution, out of the earnings and profits of CFC2, to which section 
301(c)(1) applies.
    Example 2. (i) Facts. P, a domestic corporation, wholly owns CFC1, a 
controlled foreign corporation with substantial accumulated earnings and 
profits. The CFC1 stock has a basis of $100x. CFC1 is organized in 
Country X. P also wholly owns CFC2, a controlled foreign corporation 
with zero accumulated earnings and profits. CFC2 is organized in Country 
Y. P wishes to own all of its foreign corporations in a direct chain and 
to repatriate the cash of CFC2. In order to avoid having to obtain 
Country X approval for the acquisition of CFC1 (a Country X corporation) 
by CFC2 (a Country Y corporation) and to avoid a dividend distribution 
from CFC1 to P, P forms a new corporation (CFC3) in Country X and 
transfers the stock of CFC1 to CFC3 in exchange for CFC3 stock. P then 
transfers the stock of CFC3 to CFC2 in exchange for $100x.
    (ii) Result. Because a principal purpose for the transfer of the 
stock of CFC1 (deemed issuing corporation) by P to CFC3 (issuing 
corporation) is to avoid the application of section 304 to CFC1, under 
paragraph (b)(2) of this section, for purposes of determining the amount 
of the $100x distribution constituting a dividend (and source thereof) 
under section 304(b)(2), CFC2 (acquiring corporation) shall be treated 
as acquiring the stock of CFC1 from P for $100x . As a result, P 
receives a $100x distribution, out of the earnings and profits of CFC1, 
to which section 301(c)(1) applies.

    (d) Effective/applicability date. This section applies to 
acquisitions of stock occurring on or after December 29, 2009. See Sec. 
1.304-4T, as contained in 26 CFR part 1 revised as of April 1, 2008, for 
acquisitions of stock occurring on or after June 14, 1988, and before 
December 29, 2009.
    (e) Expiration date. This section expires on or before December 28, 
2012.

[T.D. 9477, 74 FR 69023, Dec. 30, 2009; 75 FR 8796, Feb. 26, 2010]

[[Page 25]]



Sec. 1.304-5  Control.

    (a) Control requirement in general. Section 304(c)(1) provides that, 
for purposes of section 304, control means the ownership of stock 
possessing at least 50 percent of the total combined voting power of all 
classes of stock entitled to vote or at least 50 percent of the total 
value of shares of all classes of stock. Section 304(c)(3) makes section 
318(a) (relating to constructive ownership of stock), as modified by 
section 304(c)(3)(B), applicable to section 304 for purposes of 
determining control under section 304(c)(1).
    (b) Effect of section 304(c)(2)(B)--(1) In general. In determining 
whether the control test with respect to both the issuing and acquiring 
corporations is satisfied, section 304(a)(1) considers only the person 
or persons that--
    (i) Control the issuing corporation before the transaction;
    (ii) Transfer issuing corporation stock to the acquiring corporation 
for property; and
    (iii) Control the acquiring corporation thereafter.
    (2) Application. Section 317 defines property to include money, 
securities, and any other property except stock (or stock rights) in the 
distributing corporation. However, section 304(c)(2)(B) provides a 
special rule to extend the relevant group of persons to be tested for 
control of both the issuing and acquiring corporations to include the 
person or persons that do not acquire property, but rather solely stock 
from the acquiring corporation in the transaction. Section 304(c)(2)(B) 
provides that if two or more persons in control of the issuing 
corporation transfer stock of such corporation to the acquiring 
corporation, and if the transferors are in control of the acquiring 
corporation after the transfer, the person or persons in control of each 
corporation include each of those transferors. Because the purpose of 
section 304(c)(2)(B) is to include in the relevant control group the 
person or persons that retain or acquire acquiring corporation stock in 
the transaction, only the person or persons transferring stock of the 
issuing corporation that retain or acquire any proprietary interest in 
the acquiring corporation are taken into account for purposes of 
applying section 304(c)(2)(B).
    (3) Example. This section may be illustrated by the following 
example.

    Example. (a) A, the owner of 20% of T's only class of stock, 
transfers that stock to P solely in exchange for all of the P stock. 
Pursuant to the same transaction, P, solely in exchange for cash, 
acquires the remaining 80% of the T stock from T's other shareholder, B, 
who is unrelated to A and P.
    (b) Although A and B together were in control of T (the issuing 
corporation) before the transaction and A and B each transferred T stock 
to P (the acquiring corporation), sections 304(a)(1) and (c)(2)(B) do 
not apply to B because B did not retain or acquire any proprietary 
interest in P in the transaction. Section 304(a)(1) also does not apply 
to A because A (or any control group of which A was a member) did not 
control T before the transaction and P after the transaction.

    (c) Effective date. This section is effective on January 20, 1994.

[T.D. 8515, 59 FR 2960, Jan. 20, 1994]



Sec. 1.305-1  Stock dividends.

    (a) In general. Under section 305, a distribution made by a 
corporation to its shareholders in its stock or in rights to acquire its 
stock is not included in gross income except as provided in section 
305(b) and the regulations promulgated under the authority of section 
305(c). A distribution made by a corporation to its shareholders in its 
stock or rights to acquire its stock which would not otherwise be 
included in gross income by reason of section 305 shall not be so 
included merely because such distribution was made out of Treasury stock 
or consisted of rights to acquire Treasury stock. See section 307 for 
rules as to basis of stock and stock rights acquired in a distribution.
    (b) Amount of distribution. (1) In general, where a distribution of 
stock or rights to acquire stock of a corporation is treated as a 
distribution of property to which section 301 applies by reason of 
section 305(b), the amount of the distribution, in accordance with 
section 301(b) and Sec. 1.301-1, is the fair market value of such stock 
or rights on the date of distribution. See Example (1) of Sec. 1.305-
2(b).
    (2) Where a corporation which regularly distributes its earnings and 
profits, such as a regulated investment company, declares a dividend 
pursuant

[[Page 26]]

to which the shareholders may elect to receive either money or stock of 
the distributing corporation of equivalent value, the amount of the 
distribution of the stock received by any shareholder electing to 
receive stock will be considered to equal the amount of the money which 
could have been received instead. See Example (2) of Sec. 1.305-2(b).
    (3) For rules for determining the amount of the distribution where 
certain transactions, such as changes in conversion ratios or periodic 
redemptions, are treated as distributions under section 305(c), see 
Examples (6), (8), (9), and (15) of Sec. 1.305-3(e).
    (c) Adjustment in purchase price. A transfer of stock (or rights to 
acquire stock) or an increase or decrease in the conversion ratio or 
redemption price of stock which represents an adjustment of the price to 
be paid by the distributing corporation in acquiring property (within 
the meaning of section 317(a)) is not within the purview of section 305 
because it is not a distribution with respect to its stock. For example, 
assume that on January 1, 1970, pursuant to a reorganization, 
corporation X acquires all the stock of corporation Y solely in exchange 
for its convertible preferred class B stock. Under the terms of the 
class B stock, its conversion ratio is to be adjusted in 1976 under a 
formula based upon the earnings of corporation Y over the 6-year period 
ending on December 31, 1975. Such an adjustment in 1976 is not covered 
by section 305.
    (d) Definitions. (1) For purposes of this section and Sec. Sec. 
1.305-2 through 1.305-7, the term stock includes rights or warrants to 
acquire such stock.
    (2) For purposes of Sec. Sec. 1.305-2 through 1.305-7, the term 
shareholder includes a holder of rights or warrants or a holder of 
convertible securities.

[T.D. 7281, 38 FR 18532, July 12, 1973; 38 FR 19910, July 25, 1973]



Sec. 1.305-2  Distributions in lieu of money.

    (a) In general. Under section 305(b)(1), if any shareholder has the 
right to an election or option with respect to whether a distribution 
shall be made either in money or any other property, or in stock or 
rights to acquire stock of the distributing corporation, then, with 
respect to all shareholders, the distribution of stock or rights to 
acquire stock is treated as a distribution of property to which section 
301 applies regardless of--
    (1) Whether the distribution is actually made in whole or in part in 
stock or in stock rights;
    (2) Whether the election or option is exercised or exercisable 
before or after the declaration of the distribution;
    (3) Whether the declaration of the distribution provides that the 
distribution will be made in one medium unless the shareholder 
specifically requests payment in the other;
    (4) Whether the election governing the nature of the distribution is 
provided in the declaration of the distribution or in the corporate 
charter or arises from the circumstances of the distribution; or
    (5) Whether all or part of the shareholders have the election.
    (b) Examples. The application of section 305(b)(1) may be 
illustrated by the following examples:

    Example 1. (i) Corporation X declared a dividend payable in 
additional shares of its common stock to the holders of its outstanding 
common stock on the basis of two additional shares for each share held 
on the record date but with the provision that, at the election of any 
shareholder made within a specified period prior to the distribution 
date, he may receive one additional share for each share held on the 
record date plus $12 principal amount of securities of corporation Y 
owned by corporation X. The fair market value of the stock of 
corporation X on the distribution date was $10 per share. The fair 
market value of $12 principal amount of securities of corporation Y on 
the distribution date was $11 but such securities had a cost basis to 
corporation X of $9.
    (ii) The distribution to all shareholders of one additional share of 
stock of corporation X (with respect to which no election applies) for 
each share outstanding is not a distribution to which section 301 
applies.
    (iii) The distribution of the second share of stock of corporation X 
to those shareholders who do not elect to receive securities of 
corporation Y is a distribution of property to which section 301 
applies, whether such shareholders are individuals or corporations. The 
amount of the distribution to which section 301 applies is $10 per share 
of stock of corporation X held on the record date (the fair market value 
of the stock of corporation X on the distribution date).
    (iv) The distribution of securities of corporation Y in lieu of the 
second share of

[[Page 27]]

stock of corporation X to the shareholders of corporation X whether 
individuals or corporations, who elect to receive such securities, is 
also a distribution of property to which section 301 applies.
    (v) In the case of the individual shareholders of corporation X who 
elects to receive such securities, the amount of the distribution to 
which section 301 applies is $11 per share of stock of corporation X 
held on the record date (the fair market value of the $12 principal 
amount of securities of corporation Y on the distribution date).
    (vi) In the case of the corporate shareholders of corporation X 
electing to receive such securities, the amount of the distribution to 
which section 301 applies is $9 per share of stock of corporation X held 
on the record date (the basis of the securities of corporation Y in the 
hands of corporation X).
    Example 2. On January 10, 1970, corporation X, a regulated 
investment company, declared a dividend of $1 per share on its common 
stock payable on February 11, 1970, in cash or in stock of corporation X 
of equivalent value determined as of January 22, 1970, at the election 
of the shareholder made on or before January 22, 1970. The amount of the 
distribution to which section 301 applies is $1 per share whether the 
shareholder elects to take cash or stock and whether the shareholder is 
an individual or a corporation. Such amount will also be used in 
determining the dividend paid deduction of corporation X and the 
reduction in earnings and profits of corporation X.

[T.D. 7281, 38 FR 18532, July 12, 1973]



Sec. 1.305-3  Disproportionate distributions.

    (a) In general. Under section 305(b)(2), a distribution (including a 
deemed distribution) by a corporation of its stock or rights to acquire 
its stock is treated as a distribution of property to which section 301 
applies if the distribution (or a series of distributions of which such 
distribution is one) has the result of (1) the receipt of money or other 
property by some shareholders, and (2) an increase in the proportionate 
interests of other shareholders in the assets or earnings and profits of 
the corporation. Thus, if a corporation has two classes of common stock 
outstanding and cash dividends are paid on one class and stock dividends 
are paid on the other class, the stock dividends are treated as 
distributions to which section 301 applies.
    (b) Special rules. (1) As used in section 305(b)(2), the term a 
series of distributions encompasses all distributions of stock made or 
deemed made by a corporation which have the result of the receipt of 
cash or property by some shareholders and an increase in the 
proportionate interests of other shareholders.
    (2) In order for a distribution of stock to be considered as one of 
a series of distributions it is not necessary that such distribution be 
pursuant to a plan to distribute cash or property to some shareholders 
and to increase the proportionate interests of other shareholders. It is 
sufficient if there is an actual or deemed distribution of stock (of 
which such distribution is one) and as a result of such distribution or 
distributions some shareholders receive cash or property and other 
shareholders increase their proportionate interests. For example, if a 
corporation pays quarterly stock dividends to one class of common 
shareholders and annual cash dividends to another class of common 
shareholders the quarterly stock dividends constitute a series of 
distributions of stock having the result of the receipt of cash or 
property by some shareholders and an increase in the proportionate 
interests of other shareholders. This is so whether or not the stock 
distributions and the cash distributions are steps in an overall plan or 
are independent and unrelated. Accordingly, all the quarterly stock 
dividends are distributions to which section 301 applies.
    (3) There is no requirement that both elements of section 305(b)(2) 
(i.e., receipt of cash or property by some shareholders and an increase 
in proportionate interests of other shareholders) occur in the form of a 
distribution or series of distributions as long as the result of a 
distribution or distributions of stock is that some shareholders' 
proportionate interests increase and other shareholders in fact receive 
cash or property. Thus, there is no requirement that the shareholders 
receiving cash or property acquire the cash or property by way of a 
corporate distribution with respect to their shares, so long as they 
receive such cash or property in their capacity as shareholders, if 
there is a stock distribution which results in a change in the 
proportionate interests of some shareholders and other shareholders 
receive

[[Page 28]]

cash or property. However, in order for a distribution of property to 
meet the requirement of section 305(b)(2), such distribution must be 
made to a shareholder in his capacity as a shareholder, and must be a 
distribution to which section 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 
852(b), or 857(b) applies. (Under section 305(d)(2), the payment of 
interest to a holder of a convertible debenture is treated as a 
distribution of property to a shareholder for purposes of section 
305(b)(2).) For example if a corporation makes a stock distribution to 
its shareholders and, pursuant to a prearranged plan with such 
corporation, a related corporation purchases such stock from those 
shareholders who want cash, in a transaction to which section 301 
applies by virtue of section 304, the requirements of section 305(b)(2) 
are satisfied. In addition, a distribution of property incident to an 
isolated redemption of stock (for example, pursuant to a tender offer) 
will not cause section 305(b)(2) to apply even though the redemption 
distribution is treated as a distribution of property to which section 
301, 871(a)(1)(A), 881(a)(1), or 356(a)(2) applies.
    (4) Where the receipt of cash or property occurs more than 36 months 
following a distribution or series of distributions of stock, or where a 
distribution or series of distributions of stock is made more than 36 
months following the receipt of cash or property, such distribution or 
distributions will be presumed not to result in the receipt of cash or 
property by some shareholders and an increase in the proportionate 
interest of other shareholders, unless the receipt of cash or property 
and the distribution or series of distributions of stock are made 
pursuant to a plan. For example, if, pursuant to a plan, a corporation 
pays cash dividends to some shareholders on January 1, 1971 and 
increases the proportionate interests of other shareholders on March 1, 
1974, such increases in proportionate interests are distributions to 
which section 301 applies.
    (5) In determining whether a distribution or a series of 
distributions has the result of a disproportionate distribution, there 
shall be treated as outstanding stock of the distributing corporation 
(i) any right to acquire such stock (whether or not exercisable during 
the taxable year), and (ii) any security convertible into stock of the 
distributing corporation (whether or not convertible during the taxable 
year).
    (6) In cases where there is more than one class of stock 
outstanding, each class of stock is to be considered separately in 
determining whether a shareholder has increased his proportionate 
interest in the assets or earnings and profits of a corporation. The 
individual shareholders of a class of stock will be deemed to have an 
increased interest if the class of stock as a whole has an increased 
interest in the corporation.
    (c) Distributions of cash in lieu of fractional shares. (1) Section 
305(b)(2) will not apply if--
    (i) A corporation declares a dividend payable in stock of the 
corporation and distributes cash in lieu of fractional shares to which 
shareholders would otherwise be entitled, or
    (ii) Upon a conversion of convertible stock or securities a 
corporation distributes cash in lieu of fractional shares to which 
shareholders would otherwise be entitled.

Provided the purpose of the distribution of cash is to save the 
corporation the trouble, expense, and inconvenience of issuing and 
transferring fractional shares (or scrip representing fractional 
shares), or issuing full shares representing the sum of fractional 
shares, and not to give any particular group of shareholders an 
increased interest in the assets or earnings and profits of the 
corporation. For purposes of paragraph (c)(1)(i) of this section, if the 
total amount of cash distributed in lieu of fractional shares is 5 
percent or less of the total fair market value of the stock distributed 
(determined as of the date of declaration), the distribution shall be 
considered to be for such valid purpose.
    (2) In a case to which subparagraph (1) of this paragraph applies, 
the transaction will be treated as though the fractional shares were 
distributed as part of the stock distribution and then were redeemed by 
the corporation. The treatment of the cash received by a shareholder 
will be determined under section 302.

[[Page 29]]

    (d) Adjustment in conversion ratio. (1)(i) Except as provided in 
subparagraph (2) of this paragraph, if a corporation has convertible 
stock or convertible securities outstanding (upon which it pays or is 
deemed to pay dividends or interest in money or other property) and 
distributes a stock dividend (or rights to acquire such stock) with 
respect to the stock into which the convertible stock or securities are 
convertible, an increase in proportionate interest in the assets or 
earnings and profits of the corporation by reason of such stock dividend 
shall be considered to have occurred unless a full adjustment in the 
conversion ratio or conversion price to reflect such stock dividend is 
made. Under certain circumstances, however, the application of an 
adjustment formula which in effect provides for a ``credit'' where stock 
is issued for consideration in excess of the conversion price may not 
satisfy the requirement for a ``full adjustment.'' Thus, if under a 
``conversion price'' antidilution formula the formula provides for a 
``credit'' where stock is issued for consideration in excess of the 
conversion price (in effect as an offset against any decrease in the 
conversion price which would otherwise be required when stock is 
subsequently issued for consideration below the conversion price) there 
may still be an increase in proportionate interest by reason of a stock 
dividend after application of the formula, since any downward adjustment 
of the conversion price that would otherwise be required to reflect the 
stock dividend may be offset, in whole or in part, by the effect of 
prior sales made at prices above the conversion price. On the other 
hand, if there were no prior sales of stock above the conversion price 
then a full adjustment would occur upon the application of such an 
adjustment formula and there would be no change in proportionate 
interest. Similarly, if consideration is to be received in connection 
with the issuance of stock, such as in the case of a rights offering or 
a distribution of warrants, the fact that such consideration is taken 
into account in making the antidilution adjustment will not preclude a 
full adjustment. See paragraph (b) of the example in this subparagraph 
for a case where the application of an adjustment formula with a 
cumulative feature does not result in a full adjustment and where a 
change in proportionate interest therefore occurs. See paragraph (c) for 
a case where the application of an adjustment formula with a cumulative 
feature does result in a full adjustment and where no change in 
proportionate interest therefore occurs. See paragraph (d) for an 
application of an antidilution formula in the case of a rights offering. 
See paragraph (e) for a case where the application of a noncumulative 
type adjustment formula will in all cases prevent a change in 
proportionate interest from occurring in the case of a stock dividend, 
because of the omission of the cumulative feature.
    (ii) The principles of this subparagraph may be illustrated by the 
following example.

    Example. (a) Corporation S has two classes of securities 
outstanding, convertible debentures and common stock. At the time of 
issuance of the debentures the corporation had 100 shares of common 
stock outstanding. Each debenture is interest-paying and is convertible 
into common stock at a conversion price of $2. The debenture's 
conversion price is subject to reduction pursuant to the following 
formula:

    (Number of common shares outstanding at date of issue of debentures 
times initial conversion price) plus (Consideration received upon 
issuance of additional common shares) divided by (Number of common 
shares outstanding at date of issue of debentures) plus (Number of 
additional common shares issued)


Under the formula, common stock dividends are treated as an issue of 
common stock for zero consideration. If the computation results in a 
figure which is less than the existing conversion price the conversion 
price is reduced. However, under the formula, the existing conversion 
price is never increased. The formula works upon a cumulative basis 
since the numerator includes the consideration received upon the 
issuance of all common shares subsequent to the issuance of the 
debentures, and the reduction effected by the formula because of a sale 
or issuance of common stock below the existing conversion price is thus 
limited by any prior sales made above the existing conversion price.
    (b) In 1972 corporation S sells 100 common shares at $3 per share. 
In 1973 the corporation declares a stock dividend of 20 shares to all 
holders of common stock. Under the antidilution formula no adjustment 
will be

[[Page 30]]

made to the conversion price of the debentures to reflect the stock 
dividend to common stockholders since the prior sale of common stock in 
excess of the conversion price in 1972 offsets the reduction in the 
conversion price which would otherwise result, as follows:

100x$2+$300/100+120=$500/220=$2.27

Since $2.27 is greater than the existing conversion price of $2 no 
adjustment is required. As a result, there is an increase in 
proportionate interest of the common stockholders by reason of the stock 
dividend and the additional shares of common stock will be treated, 
pursuant to section 305(b)(2), as a distribution of property to which 
section 301 applies.
    (c) Assume the same facts as above, but instead of selling 100 
common shares at $3 per share in 1972, assume corporation S sold no 
shares. Application of the antidilution formula would give rise to an 
adjustment in the conversion price as follows:

100x$2+$0/100+20=$200/120=$1.67

The conversion price, being reduced from $2 to $1.67, fully reflects the 
stock dividend distributed to the common stockholders. Hence, the 
distribution of common stock is not treated under section 305(b)(2) as 
one to which section 301 applies because the distribution does not 
increase the proportionate interests of the common shareholders as a 
class.
    (d) Corporation S distributes to its shareholders rights entitling 
the shareholders to purchase a total of 20 shares at $1 per share. 
Application of the antidilution formula would produce an adjustment in 
the conversion price as follows:

100x$2+20x$1/100+20=$220/120=$1.83

The conversion price, being reduced from $2 to $1.83, fully reflects the 
distribution of rights to purchase stock at a price lower than the 
conversion price. Hence, the distribution of the rights is not treated 
under section 305(b)(2) as one to which section 301 applies because the 
distribution does not increase the proportionate interests of the common 
shareholders as a class.
    (e) Assume the same facts as in (b) above, but instead of using a 
``conversion price'' antidilution formula which operates on a cumulative 
basis, assume corporation S has employed a formula which operates as 
follows with respect to all stock dividends: The conversion price in 
effect at the opening of business on the day following the dividend 
record date is reduced by multiplying such conversion price by a 
fraction the numerator of which is the number of shares of common stock 
outstanding at the close of business on the record date and the 
denominator of which is the sum of such shares so outstanding and the 
number of shares constituting the stock dividend. Under such a formula 
the following adjustment would be made to the conversion price upon the 
declaration of a stock dividend of 20 shares in 1973:

200/200+20=200/220x$2=$1.82

The conversion price, being reduced from $2 to $1.82, fully reflects the 
stock dividend distributed to the common stockholders. Hence, the 
distribution of common stock is not treated under section 305(b)(2) as 
one to which section 301 applies because the distribution does not 
increase the proportionate interests of the common shareholders as a 
class.

    (2)(i) A distributing corporation either must make the adjustment 
required by subparagraph (1) of this paragraph as of the date of the 
distribution of the stock dividend, or must elect (in the manner 
provided in subdivision (iii) of this subparagraph) to make such 
adjustment within the time provided in subdivision (ii) of this 
subparagraph.
    (ii) If the distributing corporation elects to make such adjustment, 
such adjustment must be made no later than the earlier of (a) 3 years 
after the date of the stock dividend, or (b) that date as of which the 
aggregate stock dividends for which adjustment of the conversion ratio 
has not previously been made total at least 3 percent of the issued and 
outstanding stock with respect to which such stock dividends were 
distributed.
    (iii) The election provided by subdivision (ii) of this subparagraph 
shall be made by filing with the income tax return for the taxable year 
during which the stock dividend is distributed--
    (a) A statement that an adjustment will be made as provided by that 
subdivision, and
    (b) A description of the antidilution provisions under which the 
adjustment will be made.
    (3) Notwithstanding the preceding subparagraph, if a distribution 
has been made before July 12, 1973, and the adjustment required by 
subparagraph (1) or the election to make such adjustment was not made 
before such date, the adjustment or the election to make such 
adjustment, as the case may be, shall be considered valid if made no 
later than 15 days following the date of the first annual meeting of the 
shareholders after July 12, 1973, or July 12, 1974, whichever is 
earlier. If the election is made within such period, and, if

[[Page 31]]

the income tax return has been filed before the time of such election, 
the statement of adjustment and the description of the antidilution 
provisions required by subparagraph (2)(iii) shall be filed with the 
Internal Revenue Service Center with which the income tax return was 
filed.
    (4) See Sec. 1.305-7(b) for a discussion of antidilution 
adjustments in connection with the application of section 305(c) in 
conjunction with section 305(b).
    (e) Examples. The application of section 305(b)(2) to distributions 
of stock and section 305(c) to deemed distributions of stock may be 
illustrated by the following examples:

    Example 1. Corporation X is organized with two classes of common 
stock, class A and class B. Each share of stock is entitled to share 
equally in the assets and earnings and profits of the corporation. 
Dividends may be paid in stock or in cash on either class of stock 
without regard to the medium of payment of dividends on the other class. 
A dividend is declared on the class A stock payable in additional shares 
of class A stock and a dividend is declared on class B stock payable in 
cash. Since the class A shareholders as a class will have increased 
their proportionate interests in the assets and earnings and profits of 
the corporation and the class B shareholders will have received cash, 
the additional shares of class A stock are distributions of property to 
which section 301 applies. This is true even with respect to those 
shareholders who may own class A stock and class B stock in the same 
proportion.
    Example 2. Corporation Y is organized with two classes of stock, 
class A common, and class B, which is nonconvertible and limited and 
preferred as to dividends. A dividend is declared upon the class A stock 
payable in additional shares of class A stock and a dividend is declared 
on the class B stock payable in cash. The distribution of class A stock 
is not one to which section 301 applies because the distribution does 
not increase the proportionate interests of the class A shareholders as 
a class.
    Example 3. Corporation K is organized with two classes of stock, 
class A common, and class B, which is nonconvertible preferred stock. A 
dividend is declared upon the class A stock payable in shares of class B 
stock and a dividend is declared on the class B stock payable in cash. 
Since the class A shareholders as a class have an increased interest in 
the assets and earnings and profits of the corporation, the stock 
distribution is treated as a distribution to which section 301 applies. 
If, however, a dividend were declared upon the class A stock payable in 
a new class of preferred stock that is subordinated in all respects to 
the class B stock, the distribution would not increase the proportionate 
interests of the class A shareholders in the assets or earnings and 
profits of the corporation and would not be treated as a distribution to 
which section 301 applies.
    Example 4. (i) Corporation W has one class of stock outstanding, 
class A common. The corporation also has outstanding interest paying 
securities convertible into class A common stock which have a fixed 
conversion ratio that is not subject to full adjustment in the event 
stock dividends or rights are distributed to the class A shareholders. 
Corporation W distributes to the class A shareholders rights to acquire 
additional shares of class A stock. During the year, interest is paid on 
the convertible securities.
    (ii) The stock rights and convertible securities are considered to 
be outstanding stock of the corporation and the distribution increases 
the proportionate interests of the class A shareholders in the assets 
and earnings and profits of the corporation. Therefore, the distribution 
is treated as a distribution to which section 301 applies. The same 
result would follow if, instead of convertible securities, the 
corporation had outstanding convertible stock. If, however, the 
conversion ratio of the securities or stock were fully adjusted to 
reflect the distribution of rights to the class A shareholders, the 
rights to acquire class A stock would not increase the proportionate 
interests of the class A shareholders in the assets and earnings and 
profits of the corporation and would not be treated as a distribution to 
which section 301 applies.
    Example 5. (i) Corporation S is organized with two classes of stock, 
class A common and class B convertible preferred. The class B is fully 
protected against dilution in the event of a stock dividend or stock 
split with respect to the class A stock; however, no adjustment in the 
conversion ratio is required to be made until the stock dividends equal 
3 percent of the common stock issued and outstanding on the date of the 
first such stock dividend except that such adjustment must be made no 
later than 3 years after the date of the stock dividend. Cash dividends 
are paid annually on the class B stock.
    (ii) Corporation S pays a 1 percent stock dividend on the class A 
stock in 1970. In 1971, another 1 percent stock dividend is paid and in 
1972 another 1 percent stock dividend is paid. The conversion ratio of 
the class B stock is increased in 1972 to reflect the three stock 
dividends paid on the class A stock. The distributions of class A stock 
are not distributions to which section 301 applies because they do not 
increase the proportionate interests of the class A shareholders in the 
assets and earnings and profits of the corporation.
    Example 6. (i) Corporation M is organized with two classes of stock 
outstanding, class

[[Page 32]]

A and class B. Each class B share may be converted, at the option of the 
holder, into class A shares. During the first year, the conversion ratio 
is one share of class A stock for each share of class B stock. At the 
beginning of each subsequent year, the conversion ratio is increased by 
0.05 share of class A stock for each share of class B stock. Thus, 
during the second year, the conversion ratio would be 1.05 shares of 
class A stock for each share of class B stock, during the third year, 
the ratio would be 1.10 shares, etc.
    (ii) M pays an annual cash dividend on the class A stock. At the 
beginning of the second year, when the conversion ratio is increased to 
1.05 shares of class A stock for each share of class B stock, a 
distribution of 0.05 shares of class A stock is deemed made under 
section 305(c) with respect to each share of class B stock, since the 
proportionate interests of the class B shareholders in the assets or 
earnings and profits of M are increased and the transaction has the 
effect described in section 305(b)(2). Accordingly, sections 305(b)(2) 
and 301 apply to the transaction.
    Example 7. (i) Corporation N has two classes of stock outstanding, 
class A and class B. Each class B share is convertible into class A 
stock. However, in accordance with a specified formula, the conversion 
ratio is decreased each time a cash dividend is paid on the class B 
stock to reflect the amount of the cash dividend. The conversion ratio 
is also adjusted in the event that cash dividends are paid on the class 
A stock to increase the number of class A shares into which the class B 
shares are convertible to compensate the class B shareholders for the 
cash dividend paid on the class A stock.
    (ii) In 1972, a $1 cash dividend per share is declared and paid on 
the class B stock. On the date of payment, the conversion ratio of the 
class B stock is decreased. A distribution of stock is deemed made under 
section 305(c) to the class A shareholders, since the proportionate 
interest of the class A shareholders in the assets or earnings and 
profits of the corporation is increased and the transaction has the 
effect described in section 305(b)(2). Accordingly, sections 305(b)(2) 
and 301 apply to the transaction.
    (iii) In the following year a cash dividend is paid on the class A 
stock and none is paid on the class B stock. The increase in conversion 
rights of the class B shares is deemed to be a distribution under 
section 305(c) to the class B shareholders since their proportionate 
interest in the assets or earnings and profits of the corporation is 
increased and since the transaction has the effect described in section 
305(b)(2). Accordingly, sections 305(b)(2) and 301 apply to the 
transaction.
    Example 8. Corporation T has 1,000 shares of stock outstanding. C 
owns 100 shares. Nine other shareholders each owns 100 shares. Pursuant 
to a plan for periodic redemptions, T redeems up to 5 percent of each 
shareholder's stock each year. During the year, each of the nine other 
shareholders has 5 shares of his stock redeemed for cash. Thus, C's 
proportionate interest in the assets and earnings and profits of T is 
increased. Assuming that the cash received by the nine other 
shareholders is taxable under section 301, C is deemed under section 
305(c) to have received a distribution under section 305(b)(2) of 5.25 
shares of T stock to which section 301 applies. The amount of C's 
distribution is measured by the fair market value of the number of 
shares which would have been distributed to C had the corporation sought 
to increase his interest by 0.47 percentage points (C owned 10 percent 
of the T stock immediately before the redemption and 10.47 percent 
immediately thereafter) and the other shareholders continued to hold 900 
shares (i.e.,
    (a) 100/955=10.47% (percent of C's ownership after redemption)
    (b) 100+x/1000+x=10.47%; x=5.25 (additional shares considered to be 
distributed to C)).

Since in computing the amount of additional shares deemed to be 
distributed to C the redemption of shares is disregarded, the redemption 
of shares will be similarly disregarded in determining the value of the 
stock of the corporation which is deemed to be distributed. Thus, in the 
example, 1,005.25 shares of stock are considered as outstanding after 
the redemption. The value of each share deemed to be distributed to C is 
then determined by dividing the 1,005.25 shares into the aggregate fair 
market value of the actual shares outstanding (955) after the 
redemption.
    Example 9. (i) Corporation O has a stock redemption program under 
which, instead of paying out earnings and profits to its shareholders in 
the form of dividends, it redeems the stock of its shareholders up to a 
stated amount which is determined by the earnings and profits of the 
corporation. If the stock tendered for redemption exceeds the stated 
amount, the corporation redeems the stock on a pro rata basis up to the 
stated amount.
    (ii) During the year corporation O offers to distribute $10,000 in 
redemption of its stock. At the time of the offering, corporation O has 
1,000 shares outstanding of which E and F each owns 150 shares and G and 
H each owns 350 shares. The corporation redeems 15 shares from E and 35 
shares from G. F and H continue to hold all of their stock.
    (iii) F and H have increased their proportionate interests in the 
assets and earnings and profits of the corporation. Assuming that the 
cash E and G receive is taxable under section 301, F will be deemed 
under section 305(c) to have received a distribution under section 
305(b)(2) of 16.66 shares of stock to which section 301 applies and H 
will be deemed under section 305(c) to have received a distribution 
under section 305(b)(2) of 38.86 shares of stock to which section 301 
applies.

[[Page 33]]

The amount of the distribution to F and H is measured by the number of 
shares which would have been distributed to F and H had the corporation 
sought to increase the interest of F by 0.79 percentage points (F owned 
15 percent of the stock immediately before the redemption and 15.79 
percent immediately thereafter) and the interest of H by 1.84 percentage 
points (H owned 35 percent of the stock immediately before the 
redemption and 36.84 percent immediately thereafter) and E and G had 
continued to hold 150 shares and 350 shares, respectively (i.e.,
    (a) 150/950+350/950=52.63% (percent of F and H's ownership after 
redemption)
    (b) 500+y/1000+y=52.63%; y=55.52 (additional shares considered to be 
distributed to F and H)
    (c)(1) 150/500x55.52=16.66 (shares considered to be distributed to 
F)
    (2) 350/500x55.52=38.86 (shares considered to be distributed to H)).

Since in computing the amount of additional shares deemed to be 
distributed to F and H the redemption of shares is disregarded, the 
redemption of shares will be similarly disregarded in determining the 
value of the stock of the corporation which is deemed to be distributed. 
Thus, in the example, 1,055.52 shares of stock are considered as 
outstanding after the redemption. The value of each share deemed to be 
distributed to F and H is then determined by dividing the 1,055.52 
shares into the aggregate fair market value of the actual shares 
outstanding (950) after the redemption.
    Example 10. Corporation P has 1,000 shares of stock outstanding. T 
owns 700 shares of the P stock and G owns 300 shares of the P stock. In 
a single and isolated redemption to which section 301 applies, the 
corporation redeems 150 shares of T's stock. Since this is an isolated 
redemption and is not a part of a periodic redemption plan, G is not 
treated as having received a deemed distribution under section 305(c) to 
which sections 305(b)(2) and 301 apply even though he has an increased 
proportionate interest in the assets and earnings and profits of the 
corporation.
    Example 11. Corporation Q is a large corporation whose sole class of 
stock is widely held. However, the four largest shareholders are 
officers of the corporation and each owns 8 percent of the outstanding 
stock. In 1974, in a distribution to which section 301 applies, the 
corporation redeems 1.5 percent of the stock from each of the four 
largest shareholders in preparation for their retirement. From 1970 
through 1974, the corporation distributes annual stock dividends to its 
shareholders. No other distributions were made to these shareholders. 
Since the 1974 redemptions are isolated and are not part of a plan for 
periodically redeeming the stock of the corporation, the shareholders 
receiving stock dividends will not be treated as having received a 
distribution under section 305(b)(2) even though they have an increased 
proportionate interest in the assets and earnings and profits of the 
corporation and whether or not the redemptions are treated as 
distributions to which section 301 applies.
    Example 12. Corporation R has 2,000 shares of class A stock 
outstanding. Five shareholders own 300 shares each and five shareholders 
own 100 shares each. In preparation for the retirement of the five major 
shareholders, corporation R, in a single and isolated transaction, has a 
recapitalization in which each share of class A stock may be exchanged 
either for five shares of new class B nonconvertible preferred stock 
plus 0.4 share of new class C common stock, or for two shares of new 
class C common stock. As a result of the exchanges, each of the five 
major shareholders receives 1,500 shares of class B nonconvertible 
preferred stock and 120 shares of class C common stock. The remaining 
shareholders each receives 200 shares of class C common stock. None of 
the exchanges are within the purview of section 305.
    Example 13. Corporation P is a widely-held company whose shares are 
listed for trading on a stock exchange. P distributes annual cash 
dividends to its shareholders. P purchases shares of its common stock 
directly from small stockholders (holders of record of 100 shares or 
less) or through brokers where the holders may not be known at the time 
of purchase. Where such purchases are made through brokers, they are 
pursuant to the rules and regulations of the Securities and Exchange 
Commission. The shares are purchased for the purpose of issuance to 
employee stock investment plans, to holders of convertible stock or 
debt, to holders of stock options, or for future acquisitions. Provided 
the purchases are not pursuant to a plan to increase the proportionate 
interest of some shareholders and distribute property to other 
shareholders, the remaining shareholders of P are not treated as having 
received a deemed distribution under section 305(c) to which section 
305(b)(2) and 301 apply, even though they have an increased 
proportionate interest in the assets and earnings and profits of the 
corporation.
    Example 14. Corporation U is a large manufacturing company whose 
products are sold through independent dealers. In order to assist 
individuals who lack capital to become dealers, the corporation has an 
established investment plan under which it provides 75 percent of the 
capital necessary to form a dealership corporation and the individual 
dealer provides the remaining 25 percent. Corporation U receives class A 
stock and a note representing its 75 percent interest. The individual 
dealer receives class B stock representing his 25 percent interest. The 
class B stock is nonvoting until all the class A shares are redeemed. At 
least 70 percent of the earnings and profits of the dealership

[[Page 34]]

corporation must be used each year to retire the note and to redeem the 
class A stock. The class A stock is redeemed at a fixed price. The 
individual dealer has no control over the redemption of stock and has no 
right to have his stock redeemed during the period the plan is in 
existence. U's investment is thus systematically eliminated and the 
individual becomes the sole owner of the dealership corporation. Since 
this type of plan is akin to a security arrangement, the redemptions of 
the class A stock will not be deemed under section 305(c) as 
distributions taxable under sections 305(b)(2) and 301 during the years 
in which the class A stock is redeemed.
    Example 15. (i) Facts. Corporation V is organized with two classes 
of stock, class A common and class B convertible preferred. The class B 
stock is issued for $100 per share and is convertible at the holder's 
option into class A at a fixed ratio that is not subject to full 
adjustment in the event stock dividends or rights are distributed to the 
class A shareholders. The class B stock pays no dividends but it is 
mandatorily redeemable in 10 years for $200. Under sections 305(c) and 
305(b)(4), the entire redemption premium (i.e., the excess of the 
redemption price over the issue price) is deemed to be a distribution of 
preferred stock on preferred stock which is taxable as a distribution of 
property under section 301. This amount is considered to be distributed 
over the 10-year period under principles similar to the principles of 
section 1272(a). During the year, the corporation declares a dividend on 
the class A stock payable in additional shares of class A stock.
    (ii) Analysis. The distribution on the class A stock is a 
distribution to which sections 305(b)(2) and 301 apply since it 
increases the proportionate interests of the class A shareholders in the 
assets and earnings and profits of the corporation and the class B 
shareholders have received property (i.e., the constructive distribution 
described above). If, however, the conversion ratio of the class B stock 
were subject to full adjustment to reflect the distribution of stock to 
class A shareholders, the distribution of stock dividends on the class A 
stock would not increase the proportionate interest of the class A 
shareholders in the assets and earnings and profits of the corporation 
and such distribution would not be a distribution to which section 301 
applies.
    (iii) Effective date. This Example 15 applies to stock issued on or 
after December 20, 1995. For previously issued stock, see Sec. 1.305-
3(e) Example (15) (as contained in the 26 CFR part 1 edition revised 
April 1, 1995).

[T.D. 7281, 38 FR 18532, July 12, 1973; 38 FR 19910, 19911, July 25, 
1973; as amended by T.D. 7329, 39 FR 36860, Oct. 15, 1974; T.D. 8643, 60 
FR 66136, Dec. 21, 1995]



Sec. 1.305-4  Distributions of common and preferred stock.

    (a) In general. Under section 305(b)(3), a distribution (or a series 
of distributions) by a corporation which results in the receipt of 
preferred stock whether or not convertible into common stock) by some 
common shareholders and the receipt of common stock by other common 
shareholders is treated as a distribution of property to which section 
301 applies. For the meaning of the term a series of distribution, see 
subparagraphs (1) through (6) of Sec. 1.305-3(b).
    (b) Examples. The application of section 305(b)(3) may be 
illustrated by the following examples:

    Example 1. Corporation X is organized with two classes of common 
stock, class A and class B. Dividends may be paid in stock or in cash on 
either class of stock without regard to the medium of payment of 
dividends on the other class. A dividend is declared on the class A 
stock payable in additional shares of class A stock and a dividend is 
declared on class B stock payable in newly authorized class C stock 
which is nonconvertible and limited and preferred as to dividends. Both 
the distribution of class A shares and the distribution of new class C 
shares are distributions to which section 301 applies.
    Example 2. Corporation Y is organized with one class of stock, class 
A common. During the year the corporation declares a dividend on the 
class A stock payable in newly authorized class B preferred stock which 
is convertible into class A stock no later than 6 months from the date 
of distribution at a price that is only slightly higher than the market 
price of class A stock on the date of distribution. Taking into account 
the dividend rate, redemption provisions, the marketability of the 
convertible stock, and the conversion price, it is reasonable to 
anticipate that within a relatively short period of time some 
shareholders will exercise their conversion rights and some will not. 
Since the distribution can reasonably be expected to result in the 
receipt of preferred stock by some common shareholders and the receipt 
of common stock by other common shareholders, the distribution is a 
distribution of property to which section 301 applies.

[T.D. 7281, 38 FR 18536, July 12, 1973]



Sec. 1.305-5  Distributions on preferred stock.

    (a) In general. Under section 305(b)(4), a distribution by a 
corporation of its stock (or rights to acquire its stock) made (or 
deemed made under section

[[Page 35]]

305(c)) with respect to its preferred stock is treated as a distribution 
of property to which section 301 applies unless the distribution is made 
with respect to convertible preferred stock to take into account a stock 
dividend, stock split, or any similar event (such as the sale of stock 
at less than the fair market value pursuant to a rights offering) which 
would otherwise result in the dilution of the conversion right. For 
purposes of the preceding sentence, an adjustment in the conversion 
ratio of convertible preferred stock made solely to take into account 
the distribution by a closed end regulated investment company of a 
capital gain dividend with respect to the stock into which such stock is 
convertible shall not be considered a ``similar event.'' The term 
preferred stock generally refers to stock which, in relation to other 
classes of stock outstanding, enjoys certain limited rights and 
privileges (generally associated with specified dividend and liquidation 
priorities) but does not participate in corporate growth to any 
significant extent. The distinguishing feature of preferred stock for 
the purposes of section 305(b)(4) is not its privileged position as 
such, but that such privileged position is limited, and that such stock 
does not participate in corporate growth to any significant extent. 
However, a right to participate which lacks substance will not prevent a 
class of stock from being treated as preferred stock. Thus, stock which 
enjoys a priority as to dividends and on liquidation but which is 
entitled to participate, over and above such priority, with another less 
privileged class of stock in earnings and profits and upon liquidation, 
may nevertheless be treated as preferred stock for purposes of section 
305 if, taking into account all the facts and circumstances, it is 
reasonable to anticipate at the time a distribution is made (or is 
deemed to have been made) with respect to such stock that there is 
little or no likelihood of such stock actually participating in current 
and anticipated earnings and upon liquidation beyond its preferred 
interest. Among the facts and circumstances to be considered are the 
prior and anticipated earnings per share, the cash dividends per share, 
the book value per share, the extent of preference and of participation 
of each class, both absolutely and relative to each other, and any other 
facts which indicate whether or not the stock has a real and meaningful 
probability of actually participating in the earnings and growth of the 
corporation. The determination of whether stock is preferred for 
purposes of section 305 shall be made without regard to any right to 
convert such stock into another class of stock of the corporation. The 
term preferred stock, however, does not include convertible debentures.
    (b) Redemption premium--(1) In general. If a corporation issues 
preferred stock that may be redeemed under the circumstances described 
in this paragraph (b) at a price higher than the issue price, the 
difference (the redemption premium) is treated under section 305(c) as a 
constructive distribution (or series of constructive distributions) of 
additional stock on preferred stock that is taken into account under 
principles similar to the principles of section 1272(a). However, 
constructive distribution treatment does not result under this paragraph 
(b) if the redemption premium does not exceed a de minimis amount, as 
determined under the principles of section 1273(a)(3). For purposes of 
this paragraph (b), preferred stock that may be acquired by a person 
other than the issuer (the third person) is deemed to be redeemable 
under the circumstances described in this paragraph (b), and references 
to the issuer include the third person, if--
    (i) This paragraph (b) would apply to the stock if the third person 
were the issuer; and
    (ii) Either--
    (A) The acquisition of the stock by the third person would be 
treated as a redemption for federal income tax purposes (under section 
304 or otherwise); or
    (B) The third person and the issuer are members of the same 
affiliated group (having the meaning for this purpose given the term by 
section 1504(a), except that section 1504(b) shall not apply) and a 
principal purpose of the arrangement for the third person to acquire the 
stock is to avoid the application of section 305 and paragraph (b)(1) of 
this section.

[[Page 36]]

    (2) Mandatory redemption or holder put. Paragraph (b)(1) of this 
section applies to stock if the issuer is required to redeem the stock 
at a specified time or the holder has the option (whether or not 
currently exercisable) to require the issuer to redeem the stock. 
However, paragraph (b)(1) of this section will not apply if the issuer's 
obligation to redeem or the holder's ability to require the issuer to 
redeem is subject to a contingency that is beyond the legal or practical 
control of either the holder or the holders as a group (or through a 
related party within the meaning of section 267(b) or 707(b)), and that, 
based on all of the facts and circumstances as of the issue date, 
renders remote the likelihood of redemption. For purposes of this 
paragraph, a contingency does not include the possibility of default, 
insolvency, or similar circumstances, or that a redemption may be 
precluded by applicable law which requires that the issuer have a 
particular level of capital, surplus, or similar items. A contingency 
also does not include an issuer's option to require earlier redemption 
of the stock. For rules applicable if stock may be redeemed at more than 
one time, see paragraph (b)(4) of this section.
    (3) Issuer call--(i) In general. Paragraph (b)(1) of this section 
applies to stock by reason of the issuer's right to redeem the stock 
(even if the right is immediately exercisable), but only if, based on 
all of the facts and circumstances as of the issue date, redemption 
pursuant to that right is more likely than not to occur. However, even 
if redemption is more likely than not to occur, paragraph (b)(1) of this 
section does not apply if the redemption premium is solely in the nature 
of a penalty for premature redemption. A redemption premium is not a 
penalty for premature redemption unless it is a premium paid as a result 
of changes in economic or market conditions over which neither the 
issuer nor the holder has legal or practical control.
    (ii) Safe harbor. For purposes of this paragraph (b)(3), redemption 
pursuant to an issuer's right to redeem is not treated as more likely 
than not to occur if--
    (A) The issuer and the holder are not related within the meaning of 
section 267(b) or 707(b) (for purposes of applying sections 267(b) and 
707(b) (including section 267(f)(1)), the phrase ``20 percent'' shall be 
substituted for the phrase ``50 percent'');
    (B) There are no plans, arrangements, or agreements that effectively 
require or are intended to compel the issuer to redeem the stock 
(disregarding, for this purpose, a separate mandatory redemption 
obligation described in paragraph (b)(2) of this section); and
    (C) Exercise of the right to redeem would not reduce the yield of 
the stock, as determined under principles similar to the principles of 
section 1272(a) and the regulations under sections 1271 through 1275.
    (iii) Effect of not satisfying safe harbor. The fact that a 
redemption right is not described in paragraph (b)(3)(ii) of this 
section does not affect the determination of whether a redemption 
pursuant to the right to redeem is more likely than not to occur.
    (4) Coordination of multiple redemption provisions. If stock may be 
redeemed at more than one time, the time and price at which redemption 
is most likely to occur must be determined based on all of the facts and 
circumstances as of the issue date. Any constructive distribution under 
paragraph (b)(1) of this section will result only with respect to the 
time and price identified in the preceding sentence. However, if 
redemption does not occur at that identified time, the amount of any 
additional premium payable on any later redemption date, to the extent 
not previously treated as distributed, is treated as a constructive 
distribution over the period from the missed call or put date to that 
later date, to the extent required under the principles of this 
paragraph (b).
    (5) Consistency. The issuer's determination as to whether there is a 
constructive distribution under this paragraph (b) is binding on all 
holders of the stock, other than a holder that explicitly discloses that 
its determination as to whether there is a constructive distribution 
under this paragraph

[[Page 37]]

(b) differs from that of the issuer. Unless otherwise prescribed by the 
Commissioner, the disclosure must be made on a statement attached to the 
holder's timely filed federal income tax return for the taxable year 
that includes the date the holder acquired the stock. The issuer must 
provide the relevant information to the holder in a reasonable manner. 
For example, the issuer may provide the name or title and either the 
address or telephone number of a representative of the issuer who will 
make available to holders upon request the information required for 
holders to comply with this provision of this paragraph (b).
    (c) Cross reference. For rules for applying sections 305(b)(4) and 
305(c) to recapitalizations, see Sec. 1.305-7(c).
    (d) Examples. The application of sections 305(b)(4) and 305(c) may 
be illustrated by the following examples:

    Example 1. (i) Corporation T has outstanding 1,000 shares of $100 
par 5-percent cumulative preferred stock and 10,000 shares of no-par 
common stock. The corporation is 4 years in arrears on dividends to the 
preferred shareholders. The issue price of the preferred stock is $100 
per share. Pursuant to a recapitalization under section 368(a)(1)(E), 
the preferred shareholders exchange their preferred stock, including the 
right to dividend arrearages, on the basis of one old preferred share 
for 1.20 newly authorized class A preferred shares. Immediately 
following the recapitalization, the new class A shares are traded at 
$100 per share. The class A shares are entitled to a liquidation 
preference of $100. The preferred shareholders have increased their 
proportionate interest in the assets or earnings and profits of 
corporation T since the fair market value of 1.20 shares of class A 
preferred stock ($120) exceeds the issue price of the old preferred 
stock ($100). Accordingly, the preferred shareholders are deemed under 
section 305(c) to receive a distribution in the amount of $20 on each 
share of old preferred stock and the distribution is one to which 
sections 305(b)(4) and 301 apply.
    (ii) The same result would occur if the fair market value of the 
common stock immediately following the recapitalization were $20 per 
share and each share of preferred stock were exchanged for one share of 
the new class A preferred stock and one share of common stock.
    Example 2. Corporation A, a publicly held company whose stock is 
traded on a securities exchange (or in the over-the-counter market) has 
two classes of stock outstanding, common and cumulative preferred. Each 
share of preferred stock is convertible into .75 shares of common stock. 
There are no dividend arrearages. At the time of issue of the preferred 
stock, there was no plan or prearrangement by which it was to be 
exchanged for common stock. The issue price of the preferred stock is 
$100 per share. In order to retire the preferred stock, corporation A 
recapitalizes in a transaction to which section 368(a)(1)(E) applies and 
each share of preferred stock is exchanged for one share of common 
stock. Immediately after the recapitalization the common stock has a 
fair market value of $110 per share. Notwithstanding the fact that the 
fair market value of the common stock received in the exchange 
(determined immediately following the recapitalization) exceeds the 
issue price of the preferred stock surrendered, the recapitalization is 
not deemed under section 305(c) to result in a distribution to which 
sections 305(b)(4) and 301 apply since the recapitalization is not 
pursuant to a plan to periodically increase a shareholder's 
proportionate interest in the assets or earnings and profits and does 
not involve dividend arrearages.
    Example 3. Corporation V is organized with two classes of stock, 
1,000 shares of class A common and 1,000 shares of class B convertible 
preferred. Each share of class B stock may be converted into two shares 
of class A stock. Pursuant to a recapitalization under section 
368(a)(1)(E), the 1,000 shares of class A stock are surrendered in 
exchange for 500 shares of new class A common and 500 shares of newly 
authorized class C common. The conversion right of class B stock is 
changed to one share of class A stock and one share of class C stock for 
each share of class B stock. The change in the conversion right is not 
deemed under section 305(c) to be a distribution on preferred stock to 
which sections 305(b)(4) and 301 apply.
    Example 4. (i) Facts. Corporation X is a domestic corporation with 
only common stock outstanding. In connection with its acquisition of 
Corporation T, X issues 100 shares of its 4% preferred stock to the 
shareholders of T, who are unrelated to X both before and after the 
transaction. The issue price of the preferred stock is $40 per share. 
Each share of preferred stock is convertible at the shareholder's 
election into three shares of X common stock. At the time the preferred 
stock is issued, the X common stock has a value of $10 per share. The 
preferred stock does not provide for its mandatory redemption or for 
redemption at the option of the holder. It is callable at the option of 
X at any time beginning three years from the date of issuance for $100 
per share. There are no other plans, arrangements, or agreements that 
effectively require or are intended to compel X to redeem the stock.
    (ii) Analysis. The preferred stock is described in the safe harbor 
rule of paragraph (b)(3)(ii) of this section because X and the

[[Page 38]]

former shareholders of T are unrelated, there are no plans, 
arrangements, or agreements that effectively require or are intended to 
compel X to redeem the stock, and calling the stock for $100 per share 
would not reduce the yield of the preferred stock. Therefore, the $60 
per share call premium is not treated as a constructive distribution to 
the shareholders of the preferred stock under paragraph (b) of this 
section.
    Example 5. (i) Facts--(A) Corporation Y is a domestic corporation 
with only common stock outstanding. On January 1, 1996, Y issues 100 
shares of its 10% preferred stock to a holder. The holder is unrelated 
to Y both before and after the stock issuance. The issue price of the 
preferred stock is $100 per share. The preferred stock is--
    (1) Callable at the option of Y on or before January 1, 2001, at a 
price of $105 per share plus any accrued but unpaid dividends; and
    (2) Mandatorily redeemable on January 1, 2006, at a price of $100 
per share plus any accrued but unpaid dividends.
    (B) The preferred stock provides that if Y fails to exercise its 
option to call the preferred stock on or before January 1, 2001, the 
holder will be entitled to appoint a majority of Y's directors. Based on 
all of the facts and circumstances as of the issue date, Y is likely to 
have the legal and financial capacity to exercise its right to redeem. 
There are no other facts and circumstances as of the issue date that 
would affect whether Y will call the preferred stock on or before 
January 1, 2001.
    (ii) Analysis. Under paragraph (b)(3)(i) of this section, paragraph 
(b)(1) of this section applies because, by virtue of the change of 
control provision and the absence of any contrary facts, it is more 
likely than not that Y will exercise its option to call the preferred 
stock on or before January 1, 2001. The safe harbor rule of paragraph 
(b)(3)(ii) of this section does not apply because the provision that 
failure to call will cause the holder to gain control of the corporation 
is a plan, arrangement, or agreement that effectively requires or is 
intended to compel Y to redeem the preferred stock. Under paragraph 
(b)(4) of this section, the constructive distribution occurs over the 
period ending on January 1, 2001. Redemption is most likely to occur on 
that date, because that is the date on which the corporation minimizes 
the rate of return to the holder while preventing the holder from 
gaining control. The de minimis exception of paragraph (b)(1) of this 
section does not apply because the $5 per share difference between the 
redemption price and the issue price exceeds the amount determined under 
the principles of section 1273(a)(3) (5x.0025x$105 = $1.31). 
Accordingly, $5 per share, the difference between the redemption price 
and the issue price, is treated as a constructive distribution received 
by the holder on an economic accrual basis over the five-year period 
ending on January 1, 2001, under principles similar to the principles of 
section 1272(a).
    Example 6. Corporation A, a publicly held company whose stock is 
traded on a securities exchange (or in the over-the-counter market) has 
two classes of stock outstanding, common and preferred. The preferred 
stock is nonvoting and nonconvertible, limited and preferred as to 
dividends, and has a fixed liquidation preference. There are no dividend 
arrearages. At the time of issue of the preferred stock, there was no 
plan or prearrangement by which it was to be exchanged for common stock. 
In order to retire the preferred stock, corporation A recapitalizes in a 
transaction to which section 368(a)(1)(E) applies and the preferred 
stock is exchanged for common stock. The transaction is not deemed to be 
a distribution under section 305(c) and sections 305(b) and 301 do not 
apply to the transaction. The same result would follow if the preferred 
stock was exchanged in any reorganization described in section 368(a)(1) 
for a new preferred stock having substantially the same market value and 
having no greater call price or liquidation preference than the old 
preferred stock, whether the new preferred stock has voting rights or is 
convertible into common stock of corporation A at a fixed ratio subject 
to change solely to take account of stock dividends, stock splits, or 
similar transactions with respect to the stock into which the preferred 
stock is convertible.
    Example 7. (i) Facts--(A) Corporation Z is a domestic corporation 
with only common stock outstanding. On January 1, 1996, Z issues 100 
shares of its 10% preferred stock to C, an individual unrelated to Z 
both before and after the stock issuance. The issue price of the 
preferred stock is $100 per share. The preferred stock is--
    (1) Not callable for a period of 5 years from the issue date;
    (2) Callable at the option of Z on January 1, 2001, at a price of 
$110 per share plus any accrued but unpaid dividends;
    (3) Callable at the option of Z on July 1, 2002, at a price of $120 
per share plus any accrued but unpaid dividends; and
    (4) Mandatorily redeemable on January 1, 2004, at a price of $150 
per share plus any accrued but unpaid dividends.
    (B) There are no other plans, arrangements, or agreements between Z 
and C concerning redemption of the stock. Moreover, there are no other 
facts and circumstances as of the issue date that would affect whether Z 
will call the preferred stock on either January 1, 2001, or July 1, 
2002.
    (ii) Analysis. This stock is described in paragraph (b)(2) of this 
section because it is mandatorily redeemable. It is also potentially 
described in paragraph (b)(3)(i) of this section because it is callable 
at the option of

[[Page 39]]

the issuer. The safe harbor rule of paragraph (b)(3)(ii) of this section 
does not apply to the option to call on January 1, 2001, because the 
call would reduce the yield of the stock when compared to the yield 
produced by the January 1, 2004, mandatory redemption feature. Moreover, 
absent any other facts indicating a contrary result, the fact that 
redemption on January 1, 2001, would produce the lowest yield indicates 
that redemption is most likely to occur on that date. Under paragraph 
(b)(4) of this section, paragraph (b)(1) of this section applies with 
respect to the issuer's right to call on January 1, 2001, because 
redemption is most likely to occur on January 1, 2001, for $110 per 
share. The de minimis exception of paragraph (b)(1) of this section does 
not apply because the $10 per share difference between the redemption 
price payable in 2001 and the issue price exceeds the amount determined 
under the principles of section 1273(a)(3) (5x.0025x$110=$1.38). 
Accordingly, $10 per share, the difference between the redemption price 
and the issue price, is treated as a constructive distribution received 
by the holder on an economic accrual basis over the five-year period 
ending January 1, 2001, under principles similar to the principles of 
section 1272(a).
    (iii) Coordination rules--(A) If Z does not exercise its option to 
call the preferred stock on January 1, 2001, paragraph (b)(4) of this 
section provides that the principles of paragraph (b) of this section 
must be applied to determine if any remaining constructive distribution 
occurs. Under paragraphs (b)(3)(i) and (b)(4) of this section, paragraph 
(b)(1) of this section applies because, absent any other facts 
indicating a contrary result, the fact that redemption on July 1, 2002, 
would produce a lower yield than the yield produced by the mandatory 
redemption feature indicates that redemption on that date is most likely 
to occur. The safe harbor rule of paragraph (b)(3)(ii) of this section 
does not apply to the option to call on July 1, 2002, because, as of 
January 1, 2001, a call by Z on July 1, 2002, for $120 would reduce the 
yield of the stock. The de minimis exception of paragraph (b)(1) of this 
section does not apply because the $10 per share difference between the 
redemption price and the issue price (revised as of the missed call date 
as provided by paragraph (b)(4) of this section) exceeds the amount 
determined under the principles of section 1273(a)(3) 
(1x.0025x$120=$.30). Accordingly, the $10 per share of additional 
redemption premium that is payable on July 1, 2002, is treated as a 
constructive distribution received by the holder on an economic accrual 
basis over the period between January 1, 2001, and July 1, 2002, under 
principles similar to the principles of section 1272(a).
    (B) If Z does not exercise its second option to call the preferred 
stock on July 1, 2002, then the $30 additional redemption premium that 
is payable on January 1, 2004, is treated as a constructive distribution 
under paragraphs (b)(2) and (b)(1) of this section. The de minimis 
exception of paragraph (b)(1) of this section does not apply because the 
$30 per share difference between the redemption price and the issue 
price (revised as of the second missed call date) exceeds the amount 
determined under the principles of section 1273(a)(3) 
(1x.0025x$150=$.38). The holder is treated as receiving the constructive 
distribution on an economic accrual basis over the period between July 
1, 2002, and January 1, 2004, under principles similar to the principles 
of section 1272(a).
    Example 8. (i) Facts. The facts are the same as in paragraph (i) of 
Example 7, except that, based on all of the facts and circumstances as 
of the issue date (including an expected lack of funds on the part of 
Z), it is unlikely that Z will exercise the right to redeem on either 
January 1, 2001, or July 1, 2002.
    (ii) Analysis. The safe harbor rule of paragraph (b)(3)(ii) of this 
section does not apply to the option to call on either January 1, 2001, 
or July 1, 2002, because each call would reduce the yield of the stock. 
Under paragraph (b)(3)(i) of this section, neither option to call is 
more likely than not to occur, because, based on all of the facts and 
circumstances as of the issue date (including an expected lack of funds 
on the part of Z), it is not more likely than not that Z will exercise 
either option. However, the $50 per share redemption premium that is 
payable on January 1, 2004, is treated as a constructive distribution 
under paragraphs (b)(1) and (2) of this section, regardless of whether Z 
is anticipated to have sufficient funds to redeem on that date, because 
Z is required to redeem the stock on that date. The de minimis exception 
of paragraph (b)(1) of this section does not apply because the $50 per 
share difference between the redemption price and the issue price 
exceeds the amount determined under the principles of section 
1273(a)(3)(8x.0025x$150=$3).
    Example 9. Corporation Q is organized with 10,000 shares of class A 
stock and 1,000 shares of class B stock. The terms of the class B stock 
require that the class B have a preference of $5 per share with respect 
to dividends and $100 per share with respect to liquidation. In 
addition, upon a distribution of $10 per share to the class A stock, 
class B participates equally in any additional dividends. The terms also 
provide that upon liquidation the class B stock participates equally 
after the class A stock receives $100 per share. Corporation Q has no 
accumulated earnings and profits. In 1971 it earned $10,000, the highest 
earnings in its history. The corporation is in an industry in which it 
is reasonable to anticipate a growth in earnings of 5 percent per year. 
In 1971 the book value of corporation Q's assets totalled $100,000. In 
that year the corporation paid a dividend of $5 per share to the class B 
stock and $.50 per

[[Page 40]]

share to the class A. In 1972 the corporation had no earnings and in 
lieu of a $5 dividend distributed one share of class B stock for each 
outstanding share of class B. No distribution was made to the class A 
stock. Since, in 1972, it was not reasonable to anticipate that the 
class B stock would participate in the current and anticipated earnings 
and growth of the corporation beyond its preferred interest, the class B 
stock is preferred stock and the distribution of class B shares to the 
class B shareholders is a distribution to which sections 305(b)(4) and 
301 apply.
    Example 10. Corporation P is organized with 10,000 shares of class A 
stock and 1,000 shares of class B stock. The terms of the class B stock 
require that the class B have a preference of $5 per share with respect 
to dividends and $100 per share with respect to liquidation. In 
addition, upon a distribution of $5 per share to the class A stock, 
class B participates equally in any additional dividends. The terms also 
provide that upon liquidation the class B stock participates equally 
after the class A receives $100 per share. Corporation P has accumulated 
earnings and profits of $100,000. In 1971 it earned $75,000. The 
corporation is in an industry in which it is reasonable to anticipate a 
growth in earnings of 10 percent per year. In 1971 the book value of 
corporation P's assets totalled $5 million. In that year the corporation 
paid a dividend of $5 per share to the class B stock, $5 per share to 
the class A stock, and it distributed an additional $1 per share to both 
class A and class B stock. In 1972 the corporation had earnings of 
$82,500. In that year it paid a dividend of $5 per share to the class B 
stock and $5 per share to the class A stock. In addition, the 
corporation declared stock dividends of one share of class B stock for 
every 10 outstanding shares of class B and one share of class A stock 
for every 10 outstanding shares of class A. Since, in 1972, it was 
reasonable to anticipate that both the class B stock and the class A 
stock would participate in the current and anticipated earnings and 
growth of the corporation beyond their preferred interests, neither 
class is preferred stock and the stock dividends are not distributions 
to which section 305(b)(4) applies.

    (e) Effective date. The rules of paragraph (b) of this section and 
Examples 4, 5, 7, and 8 of paragraph (d) of this section apply to stock 
issued on or after December 20, 1995. For rules applicable to previously 
issued stock, see Sec. 1.305-5 (b) and (d) Examples (4), (5), and (7 ) 
(as contained in the 26 CFR part 1 edition revised April 1, 1995). 
Although the rules of paragraph (b) of this section and the revised 
examples do not apply to stock issued before December 20, 1995, the 
rules of sections 305(c)(1), (2), and (3) apply to stock described 
therein issued on or after October 10, 1990, except as provided in 
section 11322(b)(2) of the Revenue Reconciliation Act of 1990 (Public 
Law 101-508 Stat.). Moreover, except as provided in section 11322(b)(2) 
of the Revenue Reconciliation Act of 1990 (Public Law 101-508 Stat.), 
with respect to stock issued on or after October 10, 1990, and issued 
before December 20, 1995, the economic accrual rule of section 305(c)(3) 
will apply to the entire call premium on stock that is not described in 
paragraph (b)(2) of this section if the premium is considered to be 
unreasonable under the principles of Sec. 1.305-5(b) (as contained in 
the 26 CFR part 1 edition revised April 1, 1995). A call premium 
described in the preceding sentence will be accrued over the period of 
time during which the preferred stock cannot be called for redemption.

[T.D. 7281, 38 FR 18536, July 12, 1973, as amended by T.D. 7329, 39 FR 
36860, Oct. 15, 1974; T.D. 8643, 60 FR 66136, Dec. 21, 1995]



Sec. 1.305-6  Distributions of convertible preferred.

    (a) In general. (1) Under section 305(b)(5), a distribution by a 
corporation of its convertible preferred stock or rights to acquire such 
stock made or considered as made with respect to its stock is treated as 
a distribution of property to which section 301 applies unless the 
corporation establishes that such distribution will not result in a 
disproportionate distribution as described in Sec. 1.305-3.
    (2) The distribution of convertible preferred stock is likely to 
result in a disproportionate distribution when both of the following 
conditions exist: (i) The conversion right must be exercised within a 
relatively short period of time after the date of distribution of the 
stock; and (ii) taking into account such factors as the dividend rate, 
the redemption provisions, the marketability of the convertible stock, 
and the conversion price, it may be anticipated that some shareholders 
will exercise their conversion rights and some will not. On the other 
hand, where the conversion right may be exercised over a period of many 
years and the dividend rate is consistent with market

[[Page 41]]

conditions at the time of distribution of the stock, there is no basis 
for predicting at what time and the extent to which the stock will be 
converted and it is unlikely that a disproportionate distribution will 
result.
    (b) Examples. The application of section 305(b)(5) may be 
illustrated by the following examples:

    Example 1. Corporation Z is organized with one class of stock, class 
A common. During the year the corporation declares a dividend on the 
class A stock payable in newly authorized class B preferred stock which 
is convertible into class A stock for a period of 20 years from the date 
of issuance. Assuming dividend rates are normal in light of existing 
conditions so that there is no basis for predicting the extent to which 
the stock will be converted, the circumstances will ordinarily be 
sufficient to establish that a disproportionate distribution will not 
result since it is impossible to predict the extent to which the class B 
stock will be converted into class A stock. Accordingly, the 
distribution of class B stock is not one to which section 301 applies.
    Example 2. Corporation X is organized with one class of stock, class 
A common. During the year the corporation declares a dividend on the 
class A stock payable in newly authorized redeemable class C preferred 
stock which is convertible into class A common stock no later than 4 
months from the date of distribution at a price slightly higher than the 
market price of class A stock on the date of distribution. By 
prearrangement with corporation X, corporation Y, an insurance company, 
agrees to purchase class C stock from any shareholder who does not wish 
to convert. By reason of this prearrangement, it is anticipated that the 
shareholders will either sell the class C stock to the insurance company 
(which expects to retain the shares for investment purposes) or will 
convert. As a result, some of the shareholders exercise their conversion 
privilege and receive additional shares of class A stock, while other 
shareholders sell their class C stock to corporation Y and receive cash. 
The distribution is a distribution to which section 301 applies since it 
results in the receipt of property by some shareholders and an increase 
in the proportionate interests of other shareholders.

[T.D. 7281, 38 FR 18538, July 12, 1973]



Sec. 1.305-7  Certain transactions treated as distributions.

    (a) In general. Under section 305(c), a change in conversion ratio, 
a change in redemption price, a difference between redemption price and 
issue price, a redemption which is treated as a distribution to which 
section 301 applies, or any transaction (including a recapitalization) 
having a similar effect on the interest of any shareholder may be 
treated as a distribution with respect to any shareholder whose 
proportionate interest in the earnings and profits or assets of the 
corporation is increased by such change, difference, redemption, or 
similar transaction. In general, such change, difference, redemption, or 
similar transaction will be treated as a distribution to which sections 
305(b) and 301 apply where--
    (1) The proportionate interest of any shareholder in the earnings 
and profits or assets of the corporation deemed to have made such 
distribution is increased by such change, difference, redemption, or 
similar transaction; and
    (2) Such distribution has the result described in paragraph (2), 
(3), (4), or (5) of section 305(b).

Where such change, difference, redemption, or similar transaction is 
treated as a distribution under the provisions of this section, such 
distribution will be deemed made with respect to any shareholder whose 
interest in the earnings and profits or assets of the distributing 
corporation is increased thereby. Such distribution will be deemed to be 
a distribution of the stock of such corporation made by the corporation 
to such shareholder with respect to his stock. Depending upon the facts 
presented, the distribution may be deemed to be made in common or 
preferred stock. For example, where a redemption premium exists with 
respect to a class of preferred stock under the circumstances described 
in Sec. 1.305-5(b) and the other requirements of this section are also 
met, the distribution will be deemed made with respect to such preferred 
stock, in stock of the same class. Accordingly, the preferred 
shareholders are considered under sections 305(b)(4) and 305(c) to have 
received a distribution of preferred stock to which section 301 applies. 
See the examples in Sec. Sec. 1.305-3(e) and 1.305-5(d) for further 
illustrations of the application of section 305(c).
    (b) Antidilution provisions. (1) For purposes of applying section 
305(c) in conjunction with section 305(b), a change in the conversion 
ratio or conversion

[[Page 42]]

price of convertible preferred stock (or securities), or in the exercise 
price of rights or warrants, made pursuant to a bona fide, reasonable, 
adjustment formula (including, but not limited to, either the so-called 
``market price'' or ``conversion price'' type of formulas) which has the 
effect of preventing dilution of the interest of the holders of such 
stock (or securities) will not be considered to result in a deemed 
distribution of stock. An adjustment in the conversion ratio or price to 
compensate for cash or property distributions to other shareholders that 
are taxable under section 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 
852(b), or 857(b) will not be considered as made pursuant to a bona fide 
adjustment formula.
    (2) The principles of this paragraph may be illustrated by the 
following example:

    Example. (i) Corporation U has two classes of stock outstanding, 
class A and class B. Each class B share is convertible into class A 
stock. In accordance with a bonafide, reasonable, antidilution 
provision, the conversion price is adjusted if the corporation transfers 
class A stock to anyone for a consideration that is below the conversion 
price.
    (ii) The corporation sells class A stock to the public at the 
current market price but below the conversion price. Pursuant to the 
antidilution provision, the conversion price is adjusted downward. Such 
a change in conversion price will not be deemed to be a distribution 
under section 305(c) for the purposes of section 305(b).

    (c) Recapitalizations. (1) A recapitalization (whether or not an 
isolated transaction) will be deemed to result in a distribution to 
which section 305(c) and this section apply if--
    (i) It is pursuant to a plan to periodically increase a 
shareholder's proportionate interest in the assets or earnings and 
profits of the corporation, or
    (ii) A shareholder owning preferred stock with dividends in arrears 
exchanges his stock for other stock and, as a result, increases his 
proportionate interest in the assets or earnings and profits of the 
corporation. An increase in a preferred shareholder's proportionate 
interest occurs in any case where the fair market value or the 
liquidation preference, whichever is greater, of the stock received in 
the exchange (determined immediately following the recapitalization), 
exceeds the issue price of the preferred stock surrendered.
    (2) In a case to which subparagraph (1)(ii) of this paragraph 
applies, the amount of the distribution deemed under section 305(c) to 
result from the recapitalization is the lesser of (i) the amount by 
which the fair market value or the liquidation preference, whichever is 
greater, of the stock received in the exchange (determined immediately 
following the recapitalization) exceeds the issue price of the preferred 
stock surrendered, or (ii) the amount of the dividends in arrears.
    (3) For purposes of applying subparagraphs (1) and (2) of this 
paragraph with respect to stock issued before July 12, 1973, the term 
issue price of the preferred stock surrendered shall mean the greater of 
the issue price or the liquidation preference (not including dividends 
in arrears) of the stock surrendered.
    (4) For an illustration of the application of this paragraph, see 
Example (12) of Sec. 1.305-3(e) and Examples (1), (2), (3), and (6) of 
Sec. 1.305-5(d).
    (5) For rules relating to redemption premiums on preferred stock, 
see Sec. 1.305-5(b).

[T.D. 7281, 38 FR 18538, July 12, 1973, as amended by T.D. 8643, 60 FR 
66138, Dec. 21, 1995]



Sec. 1.305-8  Effective dates.

    (a) In general. Section 421(b) of the Tax Reform Act of 1969 (83 
Stat. 615) provides as follows:

    (b) Effective dates. (1) Except as otherwise provided in this 
subsection, the amendment made by subsection (a) shall apply with 
respect to distributions (or deemed distributions) made after January 
10, 1969, in taxable years ending after such date.
    (2)(A) Section 305(b)(2) of the Internal Revenue Code of 1954 (as 
added by subsection (a) shall not apply to a distribution (or deemed 
distribution) of stock made before January 1, 1991, with respect to 
stock (i) outstanding on January 10, 1969, (ii) issued pursuant to a 
contract binding on January 10, 1969, on the distributing corporation, 
(iii) which is additional stock of that class of stock which (as of 
January 10, 1969) had the largest fair market value of all classes of 
stock of the corporation (taking into account only stock outstanding on 
January 10, 1969, or issued pursuant to a contract binding on January 
10, 1969), (iv) described in subparagraph

[[Page 43]]

(c)(iii), or (v) issued in a prior distribution described in clause (i), 
(ii), (iii), or (iv).
    (B) Subparagraph (A) shall apply only if--
    (i) The stock as to which there is a receipt of property was 
outstanding on January 10, 1969 (or was issued pursuant to a contract 
binding on January 10, 1969, on the distributing corporation), and
    (ii) If such stock and any stock described in subparagraph (A)(i) 
were also outstanding on January 10, 1968, a distribution of property 
was made on or before January 10, 1969, with respect to such stock, and 
a distribution of stock was made on or before January 10, 1969, with 
respect to such stock described in subparagraph (A)(i).
    (C) Subparagraph (A) shall cease to apply when at any time after 
October 9, 1969, the distributing corporation issues any of its stock 
(other than in a distribution of stock with respect to stock of the same 
class) which is not--
    (i) Nonconvertible preferred stock,
    (ii) Additional stock of that class of stock which meets the 
requirements of subparagraph (A)(iii), or
    (iii) Preferred stock which is convertible into stock which meets 
the requirements of subparagraph (A)(iii) at a fixed conversion ratio 
which takes account of all stock dividends and stock splits with respect 
to the stock into which such convertible stock is convertible.
    (D) For purposes of this paragraph, the term stock includes rights 
to acquire such stock.
    (3) In cases to which Treasury Decision 6990 (promulgated January 
10, 1969) would not have applied, in applying paragraphs (1) and (2) 
April 22, 1969, shall be substituted for January 10, 1969.
    (4) Section 305(b)(4) of the Internal Revenue Code of 1954 (as added 
by subsection (a)) shall not apply to any distribution (or deemed 
distribution) with respect to preferred stock (including any increase in 
the conversation ratio of convertible stock) made before January 1, 
1991, pursuant to the terms relating to the issuance of such stock which 
were in effect on January 10, 1969.
    (5) With respect to distributions made or considered as made after 
January 10, 1969, in taxable years ending after such date, to the extent 
that the amendment made by subsection (a) does not apply by reason of 
paragraph (2), (3), or (4) of this subsection, section 305 of the 
Internal Revenue Code of 1954 (as in effect before the amendment made by 
subsection (a)) shall continue to apply.

    (b) Rules of application. (1) The rules contained in section 
421(b)(2) of the Tax Reform Act of 1969 (83 Stat. 615), hereinafter 
called ``the Act'', shall apply with respect to the application of 
section 305(b)(2), section 305(b)(3), and section 305(b)(5). Thus, for 
example, section 305(b)(5) of the Code will not apply to a distribution 
of convertible preferred stock made before January 1, 1991, with respect 
to stock outstanding on January 10, 1969 (or which was issued pursuant 
to a contract binding on the distributing corporation on January 10, 
1969), provided the distribution is pursuant to the terms relating to 
the issuance of such stock which were in effect on January 10, 1969.
    (2)(i) For purposes of section 421(b)(2)(A), (B)(i), and (C) of the 
Act, stock is considered as outstanding on January 10, 1969, if it could 
be acquired on such date or some future date by the exercise of a right 
or conversion privilege in existence on such date (including a right or 
conversion privilege with respect to stock issued pursuant to a contract 
binding, on January 10, 1969, on the distributing corporation). Thus, if 
on January 10, 1969, corporation X has outstanding 1,000 shares of class 
A common stock and 3,000 shares of class B common stock which are 
convertible on a one-to-one basis into class A stock, corporation X is 
considered for purposes of section 421(b)(2)(A), (B)(i), and (C) of the 
Act to have outstanding on January 10, 1969, 4,000 shares of class A 
stock (1,000 shares actually outstanding and 3,000 shares that could be 
acquired by the exercise of the conversion privilege contained in the 
class B stock) and 3,000 shares of class B stock.
    (ii) For the purposes of section 421(b)(2)(A) (other than for the 
purpose of determining under section 421(b)(2)(A)(iii) that class of 
stock which as of January 10, 1969, had the largest fair market value of 
all classes of stock of the corporation), (B)(i), and (C) of the Act, 
stock will be considered as outstanding on January 10, 1969, if it is 
issued pursuant to a conversion privilege contained in stock issued, 
mediately or immediately, as a stock dividend with respect to stock 
outstanding on January 10, 1969.
    (3) If, after applying subparagraph (2) of this paragraph, the class 
of stock which as of January 10, 1969, had the largest fair market value 
of all classes of stock of the corporation is a class of stock which is 
convertible into another class of nonconvertible stock, then for

[[Page 44]]

purposes of section 421(b)(2)(C)(ii) of the Act stock issued upon 
conversion of any such convertible stock (whether or not outstanding on 
January 10, 1969) into stock of such other class shall be deemed to be 
stock which meets the requirements of section 421(b)(2)(A)(iii) of the 
Act.
    (4) For purposes of section 421(b) of the Act, stock of a 
corporation held in its treasury will not be considered as outstanding 
and a distribution of such stock will be considered to be an issuance of 
such stock on the date of distribution. Stock of a parent corporation 
held by its subsidiary is not considered treasury stock.
    (5) The following stock shall not be taken into account for purposes 
of applying section 421(b)(2)(B)(i) of the Act: (i) Stock issued after 
January 10, 1969, and before October 10, 1969 (other than stock which 
was issued pursuant to a contract binding on January 10, 1969, on the 
distributing corporation); (ii) stock described in section 
421(b)(2)(C)(i), (ii), or (iii) of the Act; and (iii) stock issued, 
mediately or immediately, as a stock dividend with respect to stock of 
the same class outstanding on January 10, 1969. For example, if on June 
1, 1970, corporation Y issues additional stock of that class of stock 
which as of January 10, 1969, had the largest fair market value of all 
classes of stock of the corporation, such additional stock will not be 
taken into account for the purpose of meeting the requirement under 
section 421(b)(2)(B)(i) of the Act that the stock as to which there is a 
receipt of property must have been outstanding on January 10, 1969, and 
thus subparagraph (A) of section 421(b)(2) of the Act will not, where 
otherwise applicable, cease to apply.
    (6) Section 421(b)(2)(A) of the Act, if otherwise applicable, will 
not cease to apply if the distributing corporation issues after October 
9, 1969, securities which are convertible into stock that meets the 
requirements of section 421(b)(2)(A)(iii) of the Act at a fixed 
conversion ratio which takes account of all stock dividends and stock 
splits with respect to the stock into which the securities are 
convertible.
    (7) Under section 421(b)(4) of the Act, section 305(b)(4) does not 
apply to any distribution (or deemed distribution) by a corporation with 
respect to preferred stock made before January 1, 1991, if such 
distribution is pursuant to the terms relating to the issuance of such 
stock which were in effect on January 10, 1969. For example, if as of 
January 10, 1969, a corporation had followed the practice of paying 
stock dividends on preferred stock (or of periodically increasing the 
conversion ratio of convertible preferred stock) or if the preferred 
stock provided for a redemption price in excess of the issue price, then 
section 305(b)(4) would not apply to any distribution of stock made (or 
which would be considered made if section 305(b)(4) applied) before 
January 1, 1991, pursuant to such practice.
    (8) If section 421(b)(2) is not applicable and, for that reason, a 
distribution (or deemed distribution) is treated as a distribution to 
which section 301 applies by virtue of the application of section 
305(b)(2), (b)(3), or (b)(5), it is irrelevant that, by reason of the 
application of section 421(b)(4) of such Act, section 305(b)(4) is not 
applicable to the distribution.

[T.D. 7281, 38 FR 18539, July 12, 1973]



Sec. 1.306-1  General.

    (a) Section 306 provides, in general, that the proceeds from the 
sale or redemption of certain stock (referred to as ``section 306 
stock'') shall be treated either as ordinary income or as a distribution 
of property to which section 301 applies. Section 306 stock is defined 
in section 306(c) and is usually preferred stock received either as a 
nontaxable dividend or in a transaction in which no gain or loss is 
recognized. Section 306(b) lists certain circumstances in which the 
special rules of section 306(a) shall not apply.
    (b)(1) If a shareholder sells or otherwise disposes of section 306 
stock (other than by redemption or within the exceptions listed in 
section 306(b)), the entire proceeds received from such disposition 
shall be treated as ordinary income to the extent that the fair market 
value of the stock sold, on the date distributed to the shareholder, 
would have been a dividend to such shareholder had the distributing 
corporation distributed cash in lieu of stock. Any excess of the amount 
received over the

[[Page 45]]

sum of the amount treated as ordinary income plus the adjusted basis of 
the stock disposed of, shall be treated as gain from the sale of a 
capital asset or noncapital asset as the case may be. No loss shall be 
recognized. No reduction of earnings and profits results from any 
disposition of stock other than a redemption. The term disposition under 
section 306(a)(1) includes, among other things, pledges of stock under 
certain circumstances, particularly where the pledgee can look only to 
the stock itself as its security.
    (2) Section 306(a)(1) may be illustrated by the following examples:

    Example 1. On December 15, 1954, A and B owned equally all of the 
stock of Corporation X which files its income tax return on a calendar 
year basis. On that date Corporation X distributed pro rata 100 shares 
of preferred stock as a dividend on its outstanding common stock. On 
December 15, 1954, the preferred stock had a fair market value of 
$10,000. On December 31, 1954, the earnings and profits of Corporation X 
were $20,000. The 50 shares of preferred stock so distributed to A had 
an allocated basis to him of $10 per share or a total of $500 for the 50 
shares. Such shares had a fair market value of $5,000 when issued. A 
sold the 50 shares of preferred stock on July 1, 1955, for $6,000. Of 
this amount $5,000 will be treated as ordinary income; $500 ($6,000 
minus $5,500) will be treated as gain from the sale of a capital or 
noncapital asset as the case may be.
    Example 2. The facts are the same as in Example 1 except that A sold 
his 50 shares of preferred stock for $5,100. Of this amount $5,000 will 
be treated as ordinary income. No loss will be allowed. There will be 
added back to the basis of the common stock of Corporation X with 
respect to which the preferred stock was distributed, $400, the 
allocated basis of $500 reduced by the $100 received.
    Example 3. The facts are the same as in Example 1 except that A sold 
25 of his shares of preferred stock for $2,600. Of this amount $2,500 
will be treated as ordinary income. No loss will be allowed. There will 
be added back to the basis of the common stock of Corporation X with 
respect to which the preferred stock was distributed, $150, the 
allocated basis of $250 reduced by the $100 received.

    (c) The entire amount received by a shareholder from the redemption 
of section 306 stock shall be treated as a distribution of property 
under section 301. See also section 303 (relating to distribution in 
redemption of stock to pay death taxes).

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 7556, 43 FR 
34128, Aug. 3, 1978]



Sec. 1.306-2  Exception.

    (a) If a shareholder terminates his entire stock interest in a 
corporation--
    (1) By a sale or other disposition within the requirements of 
section 306(b)(1)(A), or
    (2) By redemption under section 302(b)(3) (through the application 
of section 306(b)(1)(B)),

the amount received from such disposition shall be treated as an amount 
received in part or full payment for the stock sold or redeemed. In the 
case of a sale, only the stock interest need be terminated. In 
determining whether an entire stock interest has been terminated under 
section 306(b)(1)(A), all of the provisions of section 318(a) (relating 
to constructive ownership of stock) shall be applicable. In determining 
whether a shareholder has terminated his entire interest in a 
corporation by a redemption of his stock under section 302(b)(3), all of 
the provisions of section 318(a) shall be applicable unless the 
shareholder meets the requirements of section 302(c)(2) (relating to 
termination of all interest in the corporation). If the requirements of 
section 302(c)(2) are met, section 318(a)(1) (relating to members of a 
family) shall be inapplicable. Under all circumstances paragraphs (2), 
(3), (4), and (5) of section 318(a) shall be applicable.
    (b) Section 306(a) does not apply to--
    (1) Redemptions of section 306 stock pursuant to a partial or 
complete liquidation of a corporation to which part II (section 331 and 
following), subchapter C, chapter 1 of the Code applies,
    (2) Exchanges of section 306 stock solely for stock in connection 
with a reorganization or in an exchange under section 351, 355, or 
section 1036 (relating to exchanges of stock for stock in the same 
corporation) to the extent that gain or loss is not recognized to the 
shareholder as the result of the exchange of the stock (see paragraph 
(d) of Sec. 1.306-3 relative to the receipt of other property), and

[[Page 46]]

    (3) A disposition or redemption, if it is established to the 
satisfaction of the Commissioner that the distribution, and the 
disposition or redemption, was not in pursuance of a plan having as one 
of its principal purposes the avoidance of Federal income tax. However, 
in the case of a prior or simultaneous disposition (or redemption) of 
the stock with respect to which the section 306 stock disposed of (or 
redeemed) was issued, it is not necessary to establish that the 
distribution was not in pursuance of such a plan. For example, in the 
absence of such a plan and of any other facts the first sentence of this 
subparagraph would be applicable to the case of dividends and isolated 
dispositions of section 306 stock by minority shareholders. Similarly, 
in the absence of such a plan and of any other facts, if a shareholder 
received a distribution of 100 shares of section 306 stock on his 
holdings of 100 shares of voting common stock in a corporation and sells 
his voting common stock before he disposes of his section 306 stock, the 
subsequent disposition of his section 306 stock would not ordinarily be 
considered a disposition one of the principal purposes of which is the 
avoidance of Federal income tax.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6969, 33 FR 
11998, Aug. 23, 1968]



Sec. 1.306-3  Section 306 stock defined.

    (a) For the purpose of subchapter C, chapter 1 of the code, the term 
section 306 stock means stock which meets the requirements of section 
306(c)(1). Any class of stock distributed to a shareholder in a 
transaction in which no amount is includible in the income of the 
shareholder or no gain or loss is recognized may be section 306 stock, 
if a distribution of money by the distributing corporation in lieu of 
such stock would have been a dividend in whole or in part. However, 
except as provided in section 306(g), if no part of a distribution of 
money by the distributing corporation in lieu of such stock would have 
been a dividend, the stock distributed will not constitute section 306 
stock.
    (b) For the purpose of section 306, rights to acquire stock shall be 
treated as stock. Such rights shall not be section 306 stock if no part 
of the distribution would have been a dividend if money had been 
distributed in lieu of the rights. When stock is acquired by the 
exercise of rights which are treated at section 306 stock, the stock 
acquired is section 306 stock. Upon the disposition of such stock (other 
than by redemption or within the exceptions listed in section 306(b)), 
the proceeds received from the disposition shall be treated as ordinary 
income to the extent that the fair market value of the stock rights, on 
the date distributed to the shareholder, would have been a dividend to 
the shareholder had the distributing corporation distributed cash in 
lieu of stock rights. Any excess of the amount realized over the sum of 
the amount treated as ordinary income plus the adjusted basis of the 
stock, shall be treated as gain from the sale of the stock.
    (c) Section 306(c)(1)(A) provides that section 306 stock is any 
stock (other than common issued with respect to common) distributed to 
the shareholder selling or otherwise disposing thereof if, under section 
305(a) (relating to distributions of stock and stock rights) any part of 
the distribution was not included in the gross income of the 
distributee.
    (d) Section 306(c)(1)(B) includes in the definition of section 306 
stock any stock except common stock, which is received by a shareholder 
in connection with a reorganization under section 368 or in a 
distribution or exchange under section 355 (or so much of section 356 as 
relates to section 355) provided the effect of the transaction is 
substantially the same as the receipt of a stock dividend, or the stock 
is received in exchange for section 306 stock. If, in a transaction to 
which section 356 is applicable, a shareholder exchanges section 306 
stock for stock and money or other property, the entire amount of such 
money and of the fair market value of the other property (not limited to 
the gain recognized) shall be treated as a distribution of property to 
which section 301 applies. Common stock received in exchange for section 
306 stock in a recapitalization shall not be considered section 306 
stock. Ordinarily, section 306 stock includes stock which is not common 
stock received in

[[Page 47]]

pursuance of a plan of reorganization (within the meaning of section 
368(a)) or received in a distribution or exchange to which section 355 
(or so much of section 356 as relates to section 355) applies if cash 
received in lieu of such stock would have been treated as a dividend 
under section 356(a)(2) or would have been treated as a distribution to 
which section 301 applies by virtue of section 356(b) or section 302(d). 
The application of the preceding sentence is illustrated by the 
following examples:

    Example 1. Corporation A, having only common stock outstanding, is 
merged in a statutory merger (qualifying as a reorganization under 
section 368(a)) with Corporation B. Pursuant to such merger, the 
shareholders of Corporation A received both common and preferred stock 
in Corporation B. The preferred stock received by such shareholders is 
section 306 stock.
    Example 2. X and Y each own one-half of the 2,000 outstanding shares 
of preferred stock and one-half of the 2,000 outstanding shares of 
common stock of Corporation C. Pursuant to a reorganization within the 
meaning of section 368(a)(1)(E) (recapitalization) each shareholder 
exchanges his preferred stock for preferred stock of a new issue which 
is not substantially different from the preferred stock previously held. 
Unless the preferred stock exchanged was itself section 306 stock the 
preferred stock received is not section 306 stock.

    (e) Section 306(c)(1)(C) includes in the definition of section 306 
stock any stock (except as provided in section 306(c)(1)(B)) the basis 
of which in the hands of the person disposing of such stock, is 
determined by reference to section 306 stock held by such shareholder or 
any other person. Under this paragraph common stock can be section 306 
stock. Thus, if a person owning section 306 stock in Corporation A 
transfers it to Corporation B which is controlled by him in exchange for 
common stock of Corporation B in a transaction to which section 351 is 
applicable, the common stock so received by him would be section 306 
stock and subject to the provisions of section 306(a) on its 
disposition. In addition, the section 306 stock transferred is section 
306 stock in the hands of Corporation B, the transferee. Section 306 
stock transferred by gift remains section 306 stock in the hands of the 
donee. Stock received in exchange for section 306 stock under section 
1036(a) (relating to exchange of stock for stock in the same 
corporation) or under so much of section 1031(b) as relates to section 
1036(a) becomes section 306 stock and acquires, for purposes of section 
306, the characteristics of the section 306 stock exchanged. The entire 
amount of the fair market value of the other property received in such 
transaction shall be considered as received upon a disposition (other 
than a redemption) to which section 306(a) applies. Section 306 stock 
ceases to be so classified if the basis of such stock is determined by 
reference to its fair market value on the date of the decedent-
stockholder's death or the optional valuation date under section 1014.
    (f) If section 306 stock which was distributed with respect to 
common stock is exchanged for common stock in the same corporation 
(whether or not such exchange is pursuant to a conversion privilege 
contained in section 306 stock), such common stock shall not be section 
306 stock. This paragraph applies to exchanges not coming within the 
purview of section 306(c)(1)(B). Common stock which is convertible into 
stock other than common stock or into property, shall not be considered 
common stock. It is immaterial whether the conversion privilege is 
contained in the stock or in some type of collateral agreement.
    (g) If there is a substantial change in the terms and conditions of 
any stock, then, for the purpose of this section--
    (1) The fair market value of such stock shall be the fair market 
value at the time of distribution or the fair market value at the time 
of such change, whichever is higher;
    (2) Such stock's ratable share of the amount which would have been a 
dividend if money had been distributed in lieu of stock shall be 
determined by reference to the time of distribution or by reference to 
the time of such change, whichever ratable share is higher; and
    (3) Section 306(c)(2) shall be inapplicable if there would have been 
a dividend to any extent if money had been distributed in lieu of the 
stock either at the time of the distribution or at the time of such 
change.

[[Page 48]]

    (h) When section 306 stock is disposed of, the amount treated under 
section 306(a)(1)(A) as ordinary income, for the purposes of part I, 
subchapter N, chapter 1 of the Code, be treated as derived from the same 
source as would have been the source if money had been received from the 
corporation as a dividend at the time of the distribution of such stock. 
If the amount is determined to be derived from sources within the United 
States, the amount shall be considered to be fixed or determinable 
annual or periodic gains, profits, and income within the meaning of 
section 871(a) or section 881(a), relating, respectively, to the tax on 
nonresident alien individuals and on foreign corporations not engaged in 
business in the United States.
    (i) Section 306 shall be inapplicable to stock received before June 
22, 1954, and to stock received on or after June 22, 1954, in 
transactions subject to the provisions of the Internal Revenue Code of 
1939.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 7281, 38 FR 
18540, July 12, 1973; T.D. 7556, 43 FR 34128, Aug. 3, 1978]



Sec. 1.307-1  General.

    (a) If a shareholder receives stock or stock rights as a 
distribution on stock previously held and under section 305 such 
distribution is not includible in gross income then, except as provided 
in section 307(b) and Sec. 1.307-2, the basis of the stock with respect 
to which the distribution was made shall be allocated between the old 
and new stocks or rights in proportion to the fair market values of each 
on the date of distribution. If a shareholder receives stock or stock 
rights as a distribution on stock previously held and pursuant to 
section 305 part of the distribution is not includible in gross income, 
then (except as provided in section 307(b) and Sec. 1.307-2) the basis 
of the stock with respect to which the distribution is made shall be 
allocated between (1) the old stock and (2) that part of the new stock 
or rights which is not includible in gross income, in proportion to the 
fair market values of each on the date of distribution. The date of 
distribution in each case shall be the date the stock or the rights are 
distributed to the stockholder and not the record date. The general rule 
will apply with respect to stock rights only if such rights are 
exercised or sold.
    (b) The application of paragraph (a) of this section is illustrated 
by the following example:

    Example. A taxpayer in 1947 purchased 100 shares of common stock at 
$100 per share and in 1954 by reason of the ownership of such stock 
acquired 100 rights entitling him to subscribe to 100 additional shares 
of such stock at $90 a share. Immediately after the issuance of the 
rights, each of the shares of stock in respect of which the rights were 
acquired had a fair market value, ex-rights, of $110 and the rights had 
a fair market value of $19 each. The basis of the rights and the common 
stock for the purpose of determining the basis for gain or loss on a 
subsequent sale or exercise of the rights or a sale of the old stock is 
computed as follows:

100 (shares)x$100=$10,000, cost of old stock (stock in respect of which 
the rights were acquired).
100 (shares)x$110=$11,000, market value of old stock.
100 (rights)x$19=$1,900, market value of rights.
11,000/12,900 of $10,000=$8,527.13, cost of old stock apportioned to 
such stock.
1,900/12,900 of $10,000=$1,472.87, cost of old stock apportioned to 
rights.


If the rights are sold, the basis for determining gain or loss will be 
$14.7287 per right. If the rights are exercised, the basis of the new 
stock acquired will be the subscription price paid therefor ($90) plus 
the basis of the rights exercised ($14.7287 each) or $104.7287 per 
share. The remaining basis of the old stock for the purpose of 
determining gain or loss on a subsequent sale will be $85.2713 per 
share.



Sec. 1.307-2  Exception.

    The basis of rights to buy stock which are excluded from gross 
income under section 305(a), shall be zero if the fair market value of 
such rights on the date of distribution is less than 15 percent of the 
fair market value of the old stock on that date, unless the shareholder 
elects to allocate part of the basis of the old stock to the rights as 
provided in paragraph (a) of Sec. 1.307-1. The election shall be made 
by a shareholder with respect to all the rights received by him in a 
particular distribution in respect of all the stock of the same class 
owned by him in the issuing corporation at the time of such 
distribution. Such election to allocate basis to rights shall be in the 
form of a

[[Page 49]]

statement attached to the shareholder's return for the year in which the 
rights are received. This election, once made, shall be irrevocable with 
respect to the rights for which the election was made. Any shareholder 
making such an election shall retain a copy of the election and of the 
tax return with which it was filed, in order to substantiate the use of 
an allocated basis upon a subsequent disposition of the stock acquired 
by exercise.

                         effects on corporation



Sec. 1.312-1  Adjustment to earnings and profits reflecting distributions by corporations.

    (a) In general, on the distribution of property by a corporation 
with respect to its stock, its earnings, and profits (to the extent 
thereof) shall be decreased by--
    (1) The amount of money,
    (2) The principal amount of the obligations of such corporation 
issued in such distribution, and
    (3) The adjusted basis of other property.

For special rule with respect to distributions to which section 312(e) 
applies, see Sec. 1.312-5.
    (b) The adjustment provided in section 312(a)(3) and paragraph 
(a)(3) of this section with respect to a distribution of property (other 
than money or its own obligations) shall be made notwithstanding the 
fact that such property has appreciated or depreciated in value since 
acquisition.
    (c) The application of paragraphs (a) and (b) of this section may be 
illustrated by the following examples:

    Example 1. Corporation A distributes to its sole shareholder 
property with a value of $10,000 and a basis of $5,000. It has $12,500 
in earnings and profits. The reduction in earnings and profits by reason 
of such distribution is $5,000. Such is the reduction even though the 
amount of $10,000 is includible in the income of the shareholder (other 
than a corporation) as a dividend.
    Example 2. The facts are the same as in Example (1) above except 
that the property has a basis of $15,000 and the earnings and profits of 
the corporation are $20,000. The reduction in earnings and profits is 
$15,000. Such is the reduction even though only the amount of $10,000 is 
includible in the income of the shareholder as a dividend.

    (d) In the case of a distribution of stock or rights to acquire 
stock a portion of which is includible in income by reason of section 
305(b), the earnings and profits shall be reduced by the fair market 
value of such portion. No reduction shall be made if a distribution of 
stock or rights to acquire stock is not includible in income under the 
provisions of section 305.
    (e) No adjustment shall be made in the amount of the earnings and 
profits of the issuing corporation upon a disposition of section 306 
stock unless such disposition is a redemption.



Sec. 1.312-2  Distribution of inventory assets.

    Section 312(b) provides for the increase and the decrease of the 
earnings and profits of a corporation which distributes, with respect to 
its stock, inventory assets as defined in section 312(b)(2), where the 
fair market value of such assets exceeds their adjusted basis. The rules 
provided in section 312(b) (relating to distributions of certain 
inventory assets) shall be applicable without regard to the method used 
in computing inventories for the purpose of the computation of taxable 
income. Section 312(b) does not apply to distributions described in 
section 312(e).



Sec. 1.312-3  Liabilities.

    The amount of any reductions in earnings and profits described in 
section 312 (a) or (b) shall be (a) reduced by the amount of any 
liability to which the property distributed was subject and by the 
amount of any other liability of the corporation assumed by the 
shareholder in connection with such distribution, and (b) increased by 
the amount of gain recognized to the corporation under section 311 (b), 
(c), or (d), or under section 341(f), 617(d), 1245(a), 1250(a), 1251(c), 
1252(a), or 1254(a).

[T.D. 7209, 37 FR 20804, Oct. 5, 1972, as amended by T.D. 8586, 60 FR 
2500, Jan. 10, 1995]



Sec. 1.312-4  Examples of adjustments provided in section 312(c).

    The adjustments provided in section 312(c) may be illustrated by the 
following examples:


[[Page 50]]


    Example 1. On December 2, 1954, Corporation X distributed to its 
sole shareholder, A, an individual, as a dividend in kind a vacant lot 
which was not an inventory asset. On that date, the lot had a fair 
market value of $5,000 and was subject to a mortgage of $2,000. The 
adjusted basis of the lot was $3,100. The amount of the earnings and 
profits was $10,000. The amount of the dividend received by A is $3,000 
($5,000, the fair market value, less $2,000, the amount of the mortgage) 
and the reduction in the earnings and profits of Corporation X is $1,100 
($3,100, the basis, less $2,000, the amount of mortgage).
    Example 2. The facts are the same as in Example (1) above with the 
exception that the amount of the mortgage to which the property was 
subject was $4,000. The amount of the dividend received by A is $1,000, 
and there is no reduction in the earnings and profits of the corporation 
as a result of the distribution (disregarding such reduction as may 
result from an increase in tax to Corporation X because, of gain 
resulting from the distribution). There is a gain of $900 recognized to 
Corporation X, the difference between the basis of the property ($3,100) 
and the amount of the mortgage ($4,000), under section 311(c) and an 
increase in earnings and profits of $900.
    Example 3. Corporation A, having accumulated earnings and profits of 
$100,000, distributed in kind to its shareholders, not in liquidation, 
inventory assets which had a basis to it on the ``Lifo'' method (section 
472) of $46,000 and on the basis of cost or market (section 471) of 
$50,000. The inventory had a fair market value of $55,000 and was 
subject to a liability of $35,000. This distribution results in a net 
decrease in earnings and profits of Corporation A of $11,000, (without 
regard to any tax on Corporation A) computed as follows:

``Fifo'' basis of inventory..........................   $50,000
Less: ``Lifo'' basis of inventory....................    46,000
                                                      ----------
Gain recognized--addition to earnings and profits (section        $4,000
 311(b)).......................................................
Adjustment to earnings and profits required by
 section 312(b)(1)(A):
  Fair market value of inventory.....................   $55,000
  Less: ``Lifo'' basis plus adjustment under section     50,000    5,000
   311(b)............................................
                                                      ------------------
 Total increase in earnings and profits........................    9,000
Decrease in earnings and profits--under section         $55,000
 312(b)(1)(B)(i).....................................
Less: Liability assumed..............................    35,000
                                                      ----------
Net amount of distribution (decrease in earnings)..............   20,000
                                                      -----------
 Net decrease in earnings and profits..........................   11,000
 



Sec. 1.312-5  Special rule for partial liquidations and certain redemptions.

    The part of the distribution properly chargeable to capital account 
within the provisions of section 312(e) shall not be considered a 
distribution of earnings and profits within the meaning of section 301 
for the purpose of determining taxability of subsequent distributions by 
the corporation.



Sec. 1.312-6  Earnings and profits.

    (a) In determining the amount of earnings and profits (whether of 
the taxable year, or accumulated since February 28, 1913, or accumulated 
before March 1, 1913) due consideration must be given to the facts, and, 
while mere bookkeeping entries increasing or decreasing surplus will not 
be conclusive, the amount of the earnings and profits in any case will 
be dependent upon the method of accounting properly employed in 
computing taxable income (or net income, as the case may be). For 
instance, a corporation keeping its books and filing its income tax 
returns under subchapter E, chapter 1 of the Code, on the cash receipts 
and disbursements basis may not use the accrual basis in determining 
earnings and profits; a corporation computing income on the installment 
basis as provided in section 453 shall, with respect to the installment 
transactions, compute earnings and profits on such basis; and an 
insurance company subject to taxation under section 831 shall exclude 
from earnings and profits that portion of any premium which is unearned 
under the provisions of section 832(b)(4) and which is segregated 
accordingly in the unearned premium reserve.
    (b) Among the items entering into the computation of corporate 
earnings and profits for a particular period are all income exempted by 
statute, income not taxable by the Federal Government under the 
Constitution, as well as all items includible in gross income under 
section 61 or corresponding provisions of prior revenue acts. Gains and 
losses within the purview of section 1002 or corresponding provisions of 
prior revenue acts are brought into the earnings and profits at the time 
and to the extent such gains and losses are recognized under that 
section. Interest on State bonds and certain other obligations, although 
not taxable when received by a corporation, is taxable to the same 
extent as other dividends

[[Page 51]]

when distributed to shareholders in the form of dividends.
    (c)(1) In the case of a corporation in which depletion or 
depreciation is a factor in the determination of income, the only 
depletion or depreciation deductions to be considered in the computation 
of the total earnings and profits are those based on cost or other basis 
without regard to March 1, 1913, value. In computing the earnings and 
profits for any period beginning after February 28, 1913, the only 
depletion or depreciation deductions to be considered are those based on 
(i) cost or other basis, if the depletable or depreciable asset was 
acquired subsequent to February 28, 1913, or (ii) adjusted cost or March 
1, 1913, value, whichever is higher, if acquired before March 1, 1913. 
Thus, discovery or percentage depletion under all revenue acts for mines 
and oil and gas wells is not to be taken into consideration in computing 
the earnings and profits of a corporation. Similarly, where the basis of 
property in the hands of a corporation is a substituted basis, such 
basis, and not the fair market value of the property at the time of the 
acquisition by the corporation, is the basis for computing depletion and 
depreciation for the purpose of determining earnings and profits of the 
corporation.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example. Oil producing property which A had acquired in 1949 at a 
cost of $28,000 was transferred to Corporation Y in December 1951, in 
exchange for all of its capital stock. The fair market value of the 
stock and of the property as of the date of the transfer was $247,000. 
Corporation Y, after four years' operation, effected in 1955 a cash 
distribution to A in the amount of $165,000. In determining the extent 
to which the earnings and profits of Corporation Y available for 
dividend distributions have been increased as the result of production 
and sale of oil, the depletion to be taken into account is to be 
computed upon the basis of $28,000 established in the nontaxable 
exchange in 1951 regardless of the fair market value of the property or 
of the stock issued in exchange therefor.

    (d) A loss sustained for a year before the taxable year does not 
affect the earnings and profits of the taxable year. However, in 
determining the earnings and profits accumulated since February 28, 
1913, the excess of a loss sustained for a year subsequent to February 
28, 1913, over the undistributed earnings and profits accumulated since 
February 28, 1913, and before the year for which the loss was sustained, 
reduces surplus as of March 1, 1913, to the extent of such excess. If 
the surplus as of March 1, 1913, was sufficient to absorb such excess, 
distributions to shareholders after the year of the loss are out of 
earnings and profits accumulated since the year of the loss to the 
extent of such earnings.
    (e) With respect to the effect on the earnings and profits 
accumulated since February 28, 1913, of distributions made on or after 
January 1, 1916, and before August 6, 1917, out of earnings or profits 
accumulated before March 1, 1913, which distributions were specifically 
declared to be out of earnings and profits accumulated before March 1, 
1913, see section 31(b) of the Revenue Act of 1916, as added by section 
1211 of the Revenue Act of 1917 (40 Stat. 336).



Sec. 1.312-7  Effect on earnings and profits of gain or loss realized after February 28, 1913.

    (a) In order to determine the effect on earnings and profits of gain 
or loss realized from the sale or other disposition (after February 28, 
1913) of property by a corporation, section 312(f)(1) prescribed certain 
rules for--
    (1) The computation of the total earnings and profits of the 
corporation of most frequent application in determining invested 
capital; and
    (2) The computation of earnings and profits of the corporation for 
any period beginning after February 28, 1913, of most frequent 
application in determining the source of dividend distributions.

Such rules are applicable whenever under any provision of subtitle A of 
the Code it is necessary to compute either the total earnings and 
profits of the corporation or the earnings and profits for any period 
beginning after February 28, 1913. For example, since the earnings and 
profits accumulated after February 28, 1913, or the earnings and profits 
of the taxable year, are earnings and profits for a period beginning

[[Page 52]]

after February 28, 1913, the determination of either must be in 
accordance with the regulations prescribed by this section for the 
ascertainment of earnings and profits for any period beginning after 
February 28, 1913. Under subparagraph (1) of this paragraph, such gain 
or loss is determined by using the adjusted basis (under the law 
applicable to the year in which the sale or other disposition was made) 
for determining gain, but disregarding value as of March 1, 1913. Under 
subparagraph (2) of this paragraph, there is used such adjusted basis 
for determining gain, giving effect to the value as of March 1, 1913, 
whenever applicable. In both cases the rules are the same as those 
governing depreciation and depletion in computing earnings and profits 
(see Sec. 1.312-6). Under both subparagraphs (1) and (2) of this 
paragraph, the adjusted basis is subject to the limitations of the third 
sentence of section 312(f)(1) requiring the use of adjustments proper in 
determining earnings and profits. The proper adjustments may differ 
under section 312(f)(1)(A) and (B) depending upon the basis to which the 
adjustments are to be made. If the application of section 312(f)(1)(B) 
results in a loss and if the application of section 312(f)(1)(A) to the 
same transaction reaches a different result, then the loss under section 
312(f)(1)(B) will be subject to the adjustment thereto required by 
section 312(g)(2). (See Sec. 1.312-9.)
    (b)(1) The gain or loss so realized increases or decreases the 
earnings and profits to, but not beyond, the extent to which such gain 
or loss was recognized in computing taxable income (or net income, as 
the case may be) under the law applicable to the year in which such sale 
or disposition was made. As used in this paragraph, the term 
``recognized'' has reference to that kind of realized gain or loss which 
is recognized for income tax purposes by the statute applicable to the 
year in which the gain or loss was realized. For example, see section 
356. A loss (other than a wash sale loss with respect to which a 
deduction is disallowed under the provisions of section 1091 or 
corresponding provisions of prior revenue laws) may be recognized though 
not allowed as a deduction (by reason, for example, of the operation of 
sections 267 and 1211 and corresponding provisions of prior revenue 
laws) but the mere fact that it is not allowed does not prevent decrease 
in earnings and profits by the amount of such disallowed loss. Wash sale 
losses, however, disallowed under section 1091 and corresponding 
provisions of prior revenue laws, are deemed nonrecognized losses and do 
not reduce earnings or profits. The recognized gain or loss for the 
purpose of computing earnings and profits is determined by applying the 
recognition provisions to the realized gain or loss computed under the 
provisions of section 312(f)(1) as distinguished from the realized gain 
or loss used in computing taxable income (or net income, as the case may 
be).
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following examples:

    Example 1. Corporation X on January 1, 1952, owned stock in 
Corporation Y which it had acquired from Corporation Y in December 1951, 
in an exchange transaction in which no gain or loss was recognized. The 
adjusted basis to Corporation X of the property exchanged by it for the 
stock in Corporation Y was $30,000. The fair market value of the stock 
in Corporation Y when received by Corporation X was $930,000. On April 
9, 1955, Corporation X made a cash distribution of $900,000 and, except 
for the possible effect of the transaction in 1951, had no earnings or 
profits accumulated after February 28, 1913, and had no earnings or 
profits for the taxable year. The amount of $900,000 representing the 
excess of the fair market value of the stock of Corporation Y over the 
adjusted basis of the property exchanged therefor was not recognized 
gain to Corporation X under the provisions of section 112 of the 
Internal Revenue Code of 1939. Accordingly, the earnings and profits of 
Corporation X are not increased by $900,000, the amount of the gain 
realized but not recognized in the exchange, and the distribution was 
not a taxable dividend. The basis in the hands of Corporation Y of the 
property acquired by it from Corporation X is $30,000. If such property 
is thereafter sold by Corporation Y, gain or loss will be computed on 
such basis of $30,000, and earnings and profits will be increased or 
decreased accordingly.
    Example 2. On January 2, 1910, Corporation M acquired nondepreciable 
property at a cost of $1,000. On March 1, 1913, the fair market value of 
such property in the hands of Corporation M was $2,200. On December 31, 
1952, Corporation M transfers such property to Corporation N in exchange 
for $1,900 in cash and all Corporation N's stock, which has a

[[Page 53]]

fair market value of $1,100. For the purpose of computing the total 
earnings and profits of Corporation M, the gain on such transaction is 
$2,000 (the sum of $1,900 in cash and stock worth $1,100 minus $1,000, 
the adjusted basis for computing gain, determined without regard to 
March 1, 1913, value), $1,900 of which is recognized under section 356, 
since this was the amount of money received, although for the purpose of 
computing net income the gain is only $800 (the sum of $1,900 in cash 
and stock worth $1,100, minus $2,200, the adjusted basis for computing 
gain determined by giving effect to March 1, 1913, value). Such earnings 
and profits will therefore be increased by only $800 as a reputing the 
earnings and profits of Corporation M for any period beginning after 
February 28, 1913, however, the gain arising from the transaction, like 
the taxable gain, is only $800, all of which is recognized under section 
112(c) of the Internal Revenue Code of 1939, the money received being in 
excess of such amount. Such earnings and profits will therefore be 
increased by only $800 as a result of the transaction. For increase in 
that part of the earnings and profits consisting of increase in value of 
property accrued before, but realized on or after March 1, 1913, see 
Sec. 1.312-9.
    Example 3. On July 31, 1955, Corporation R owned oil-producing 
property acquired after February 28, 1913, at a cost of $200,000, but 
having an adjusted basis (by reason of taking percentage depletion) of 
$100,000 for determining gain. However, the adjusted basis of such 
property to be used in computing gain or loss for the purpose of 
earnings and profits is, because of the provisions of the third sentence 
of section 312(f)(1), $150,000. On such day Corporation R transferred 
such property to Corporation S in exchange for $25,000 in cash and all 
of the stock of Corporation S, which had a fair market value of 
$100,000. For the purpose of computing taxable income, Corporation R has 
realized a gain of $25,000 as a result of this transaction, all of which 
is recognized under section 356. For the purpose of computing earnings 
and profits, however, Corporation R has realized a loss of $25,000, none 
of which is recognized owing to the provisions of section 356(c). The 
earnings and profits of Corporation R are therefore neither increased 
nor decreased as a result of the transaction. The adjusted basis of the 
Corporation S stock in the hands of Corporation R for purposes of 
computing earnings and profits, however, will be $125,000 (though only 
$100,000 for the purpose of computing taxable income), computed as 
follows:

Basis of property transferred................................   $200,000
Less money received on exchange..............................     25,000
Plus gain or minus loss recognized on exchange...............       None
                                                              ----------
 Basis of stock..............................................    175,000
Less adjustments (same as those used in determining adjusted      50,000
 basis of property transferred)..............................
                                                              ----------
 Adjusted basis of stock.....................................    125,000
 


If, therefore, Corporation R should subsequently sell the Corporation S 
stock for $100,000, a loss of $25,000 will again be realized for the 
purpose of computing earnings and profits, all of which will be 
recognized and will be applied to decrease the earnings and profits of 
Corporation R.

    (c)(1) The third sentence of section 312(f)(1) provides for cases in 
which the adjustments, prescribed in section 1016, to the basis 
indicated in section 312(f)(1)(A) or (B), as the case may be, differ 
from the adjustments to such basis proper for the purpose of determining 
earnings or profits. The adjustments provided by such third sentence 
reflect the treatment provided by Sec. Sec. 1.312-6 and 1.312-15 
relative to cases where the deductions for depletion and depreciation in 
computing taxable income (or net income, as the case may be) differ from 
the deductions proper for the purpose of computing earnings and profits.
    (2) The effect of the third sentence of section 312(f)(1) may be 
illustrated by the following examples:

    Example 1. Corporation X purchased on January 2, 1931, an oil lease 
at a cost of $10,000. The lease was operated only for the years 1931 and 
1932. The deduction for depletion in each of the years 1931 and 1932 
amounted to $2,750, of which amount $1,750 represented percentage 
depletion in excess of depletion based on cost. The lease was sold in 
1955 for $15,000. Under section 1016(a)(2), in determining the gain or 
loss from the sale of the property, the basis must be adjusted for cost 
depletion of $1,000 in 1931 and percentage depletion of $2,750 in 1932. 
However, the adjustment of such basis, proper for the determination of 
earnings and profits, is $1,000 for each year, or $2,000. Hence, the 
cost is to be adjusted only to the extent of $2,000, leaving an adjusted 
basis of $8,000 and the earnings and profits will be increased by 
$7,000, and not by $8,750. The difference of $1,750 is equal to the 
amount by which the percentage depletion for the year 1932 ($2,750) 
exceeds the depletion on cost for that year ($1,000) and has already 
been applied in the computation of earnings and profits for the year 
1932 by taking into account only $1,000 instead of $2,750 for depletion 
in the computation of such earnings and profits. (See Sec. 1.316-1.)
    Example 2. If, in Example (1), above, the property, instead of being 
sold, is exchanged in a transaction described in section 1031 for like 
property having a fair market value of $7,750 and cash of $7,250, then 
the increase in earnings and profits amounts to $7,000, that is, $15,000 
($7,750 plus $7,250) minus the basis

[[Page 54]]

of $8,000. However, in computing taxable income of Corporation X, the 
gain is $8,750, that is, $15,000 minus $6,250 ($10,000 less depletion of 
$3,750), of which only $7,250 is recognized because the recognized gain 
cannot exceed the sum of money received in the transaction. See section 
1031(b) and the corresponding provisions of prior revenue laws. If, 
however, the cash received was only $2,250 and the value of the property 
received was $12,750, then the increase in earnings and profits would be 
$2,250, that amount being the gain recognized under section 1031.
    Example 3. On January 1, 1973, corporation X purchased for $10,000 a 
depreciable asset with an estimated useful life of 20 years and no 
salvage value. In computing depreciation on the asset, corporation X 
used the declining balance method with a rate twice the straight line 
rate. On December 31, 1976, the asset was sold for $9,000. Under section 
1016(a)(2), the basis of the asset is adjusted for depreciation allowed 
for the years 1973 through 1976, or a total of $3,439. Thus, X realizes 
a gain of $2,439 (the excess of the amount realized, $9,000, over the 
adjusted basis, $6,561). However, the proper adjustment to basis for the 
purpose of determining earnings and profits is only $2,000, i.e., the 
total amount which, under Sec. 1.312-15, was applied in the computation 
of earnings and profits for the years 1973-76. Hence, upon sale of the 
asset, earnings and profits are increased by only $1,000, i.e., the 
excess of the amount realized, $9,000, over the adjusted basis for 
earnings and profits purposes, $8,000.

    (d) For adjustment and allocation of the earnings and profits of the 
transferor as between the transferor and the transferee in cases where 
the transfer of property by one corporation to another corporation 
results in the nonrecognition in whole or in part of gain or loss, see 
Sec. 1.312-10; and see section 381 for earnings and profits of 
successor corporations in certain transactions.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 7221, 37 FR 
24746, Nov. 21, 1972]



Sec. 1.312-8  Effect on earnings and profits of receipt of tax-free 

distributions requiring adjustment or allocation of basis of stock.

    (a) In order to determine the effect on earnings and profits, where 
a corporation receives (after February 28, 1913) from a second 
corporation a distribution which (under the law applicable to the year 
in which the distribution was made) was not a taxable dividend to the 
shareholders of the second corporation, section 312(f) prescribes 
certain rules. It provides that the amount of such distribution shall 
not increase the earnings and profits of the first or receiving 
corporation in the following cases: (1) No such increase shall be made 
in respect of the part of such distribution which (under the law 
applicable to the year in which the distribution was made) is directly 
applied in reduction of the basis of the stock in respect of which the 
distribution was made and (2) no such increase shall be made if (under 
the law applicable to the year in which the distribution was made) the 
distribution causes the basis of the stock in respect of which the 
distribution was made to be allocated between such stock and the 
property received (or such basis would but for section 307(b) be so 
allocated). Where, therefore, the law (applicable to the year in which 
the distribution was made, as, for example, a distribution in 1934 from 
earnings and profits accumulated before March 1, 1913) requires that the 
amount of such distribution shall be applied against and reduce the 
basis of the stock with respect to which the distribution was made, 
there is no increase in the earnings and profits by reason of the 
receipt of such distribution. Similarly, where there is received by a 
corporation a distribution from another corporation in the form of a 
stock dividend and the law applicable to the year in which such 
distribution was made requires the allocation, as between the old stock 
and the stock received as a dividend, of the basis of the old stock (or 
such basis would but for section 307(b) be so allocated), then there is 
no increase in the earnings and profits by reason of the receipt of such 
stock dividend even though such stock dividend constitutes income within 
the meaning of the sixteenth amendment to the Constitution.
    (b) The principles set forth in paragraph (a) of this section may be 
illustrated by the following examples:

    Example 1. Corporation X in 1955 distributed to Corporation Y, one 
of its shareholders, $10,000 which was out of earnings or profits 
accumulated before March 1, 1913, and did not exceed the adjusted basis 
of the stock in respect of which the distribution was made. This amount 
of $10,000 was, therefore, a tax-free distribution and under the 
provisions of section 301(c)(2) must be applied

[[Page 55]]

against and reduce the adjusted basis of the stock in respect of which 
the distribution was made. The earnings and profits of Corporation Y are 
not increased by reason of the receipt of this distribution.
    Example 2. Corporation Z in 1955 had outstanding common and 
preferred stock of which Corporation Y held 100 shares of the common and 
no preferred. The stock had a cost basis to Corporation Y of $100 per 
share, or a total cost of $10,000. In December of that year it received 
a dividend of 100 shares of the preferred stock of Corporation Z. Such 
distribution is a stock dividend which, under section 305, was not 
taxable and was accordingly not included in the gross income of 
Corporation Y. The original cost of $10,000 is allocated to the 200 
shares of Corporation Z none of which has been sold or otherwise 
disposed of by Corporation Y. See section 307 and Sec. 1.307-1. The 
earnings and profits of Corporation Y are not increased by reason of the 
receipt of such stock dividend.



Sec. 1.312-9  Adjustments to earnings and profits reflecting increase in

value accrued before March 1, 1913.

    (a) In order to determine, for the purpose of ascertaining the 
source of dividend distributions, that part of the earnings and profits 
which is represented by increase in value of property accrued before, 
but realized on or after, March 1, 1913, section 312(g) prescribes 
certain rules.
    (b)(1) Section 312(g)(1) sets forth the general rule with respect to 
computing the increase to be made in that part of the earnings and 
profits consisting of increase in value of property accrued before, but 
realized on or after, March 1, 1913.
    (2) The effect of section 312(g)(1) may be illustrated by the 
following examples:

    Example 1. Corporation X acquired nondepreciable property before 
March 1, 1913, at a cost of $10,000. Its fair market value as of March 
1, 1913, was $12,000 and it was sold in 1955 for $15,000. The increase 
in earnings and profits based on the value as of March 1, 1913, 
representing earnings and profits accumulated since February 28, 1913, 
is $3,000. If the basis is determined without regard to the value as of 
March 1, 1913, there would be an increase in earnings and profits of 
$5,000. The difference of $2,000 ($5,000 minus $3,000) represents the 
increase to be made in that part of the earnings and profits of 
Corporation X consisting of the increase in value of property accrued 
before, but realized on or after, March 1, 1913.
    Example 2. Corporation Y acquired depreciable property in 1908 at a 
cost of $100,000. Assuming no additions or betterments, and that the 
depreciation sustained before March 1, 1913, was $10,000, the adjusted 
cost as of that date was $90,000. Its fair market value as of March 1, 
1913, was $94,000 and on February 28, 1955, it was sold for $25,000. For 
the purpose of determining gain from the sale, the basis of the property 
is the fair market value of $94,000 as of March 1, 1913, adjusted for 
depreciation for the period subsequent to February 28, 1913, computed on 
such fair market value. If the amount of the depreciation deduction 
allowed after February 28, 1913, and properly allowable for each of such 
years to the date of the sale in 1955 is the aggregate sum of $81,467, 
the adjusted basis for determining gain in 1955 ($94,000 less $81,467) 
is $12,533 and the gain would be $12,467 ($25,000 less $12,533). The 
increase in earnings and profits accumulated since February 28, 1913, by 
reason of the sale, based on the value as of March 1, 1913, adjusted for 
depreciation is $12,467. If the depreciation since February 28, 1913, 
had been based on the adjusted cost of $90,000 ($100,000 less $10,000) 
instead of the March 1, 1913, value of $94,000, the depreciation 
sustained from that date to the date of sale would have been $78,000 
instead of $81,467 and the actual gain on the sale based on the cost of 
$100,000 adjusted by depreciation on such cost to $12,000 ($100,000 
reduced by the sum of $10,000 and $78,000) would be $13,000 ($25,000 
less $12,000). If the adjusted basis of the property was determined 
without regard to the value as of March 1, 1913, there would be an 
increase in earnings and profits of $13,000. The difference of $533 
($13,000 minus $12,467) represents the increase to be made in that part 
of the earnings and profits of Corporation Y consisting of the increase 
in value of property accrued before, but realized on or after, March 1, 
1913 (assuming that the proper increase in such surplus had been made 
each year for the difference between depreciation based on cost and the 
depreciation based on March 1, 1913, value). Thus, the total increase in 
that part of earnings and profits consisting of the increase in value of 
property accrued before, but realized on or after, March 1, 1913, is 
$4,000 ($94,000 less $90,000).

    (c)(1) Section 312(g)(2) is an exception to the general rule in 
section 312(g)(1) and also operates as a limitation on the application 
of section 312(f). It provides that, if the application of section 
312(f)(1)(B) to a sale or other disposition after February 28, 1913, 
results in a loss which is to be applied in decrease of earnings and 
profits for any period beginning after February 28, 1913, then, 
notwithstanding section 312(f) and in lieu of the rule provided in 
section

[[Page 56]]

312(g)(1), the amount of such loss so to be applied shall be reduced by 
the amount, if any, by which the adjusted basis of the property used in 
determining the loss, exceeds the adjusted basis computed without regard 
to the fair market value of the property on March 1, 1913. If the amount 
so applied in reduction of the loss exceeds such loss, the excess over 
such loss shall increase that part of the earnings and profits 
consisting of increase in value of property accrued before, but realized 
on or after March 1, 1913.
    (2) The application of section 312(g)(2) may be illustrated by the 
following examples:

    Example 1. Corporation Y acquired nondepreciable property before 
March 1, 1913, at a cost of $8,000. Its fair market value as of March 1, 
1913, was $13,000, and it was sold in 1955 for $10,000. Under section 
312(f)(1)(B) the adjusted basis would be $13,000 and there would be a 
loss of $3,000. The application of section 312(f)(1)(B) would result in 
a loss from the sale in 1955 to be applied in decrease of earnings and 
profits for that year. Section 312(g)(2), however, applies and the loss 
of $3,000 is reduced by the amount by which the adjusted basis of 
$13,000 exceeds the cost of $8,000 (the adjusted basis computed without 
regard to the value on March 1, 1913), namely $5,000. The amount of the 
loss is, accordingly, reduced from $3,000 to zero and there is no 
decrease in earnings and profits of Corporation Y for the year 1955 as a 
result of the sale. The amount applied in reduction of the decrease, 
namely, $5,000, exceeds $3,000. Accordingly, as a result of the sale the 
excess of $2,000 increases that part of the earnings and profits of 
Corporation Y consisting of increase in value of property accrued 
before, but realized on or after March 1, 1913.
    Example 2. Corporation Z acquired nondepreciable property before 
March 1, 1913, at a cost of $10,000. Its fair market value as of March 
1, 1913, was $12,000, and it was sold in 1955 for $8,000. Under section 
312(f)(1)(B) the adjusted basis would be $12,000 and there would be a 
loss of $4,000. The application of section 312(f)(1)(B) would result in 
a loss from the sale in 1955 to be applied in decrease of earnings and 
profits for that year. Section 312(g)(2), however, applies and the loss 
of $4,000 is reduced by the amount by which the adjusted basis of 
$12,000 exceeds the cost of $10,000 (the adjusted basis computed without 
regard to the value on March 1, 1913), namely, $2,000. The amount of the 
loss is, accordingly, reduced from $4,000 to $2,000 and the decrease in 
earnings and profits of Corporation Z for the year 1955 as a result of 
the sale is $2,000 instead of $4,000. The amount applied in reduction of 
the decrease, namely, $2,000, does not exceed $4,000. Accordingly, as a 
result of the sale there is no increase in that part of the earnings and 
profits of Corporation Z consisting of increase in value of property 
accrued before, but realized on or after, March 1, 1913.



Sec. 1.312-10  Allocation of earnings in certain corporate separations.

    (a) If one corporation transfers part of its assets constituting an 
active trade or business to another corporation in a transaction to 
which section 368(a)(1)(4) applies and immediately thereafter the stock 
and securities of the controlled corporation are distributed in a 
distribution or exchange to which section 355 (or so much of section 356 
as relates to section 355) applies, the earnings and profits of the 
distributing corporation immediately before the transaction shall be 
allocated between the distributing corporation and the controlled 
corporation. In the case of a newly created controlled corporation, such 
allocation generally shall be made in proportion to the fair market 
value of the business or businesses (and interests in any other 
properties) retained by the distributing corporation and the business or 
businesses (and interests in any other properties) of the controlled 
corporation immediately after the transaction. In a proper case, 
allocation shall be made between the distributing corporation and the 
controlled corporation in proportion to the net basis of the assets 
transferred and of the assets retained or by such other method as may be 
appropriate under the facts and circumstances of the case. The term net 
basis means the basis of the assets less liabilities assumed or 
liabilities to which such assets are subject. The part of the earnings 
and profits of the taxable year of the distributing corporation in which 
the transaction occurs allocable to the controlled corporation shall be 
included in the computation of the earnings and profits of the first 
taxable year of the controlled corporation ending after the date of the 
transaction.
    (b) If a distribution or exchange to which section 355 applies (or 
so much of section 356 as relates to section 355) is not in pursuance of 
a plan meeting the

[[Page 57]]

requirements of a reorganization as defined in section 368(a)(1)(D), the 
earnings and profits of the distributing corporation shall be decreased 
by the lesser of the following amounts:
    (1) The amount by which the earnings and profits of the distributing 
corporation would have been decreased if it had transferred the stock of 
the controlled corporation to a new corporation in a reorganization to 
which section 368(a)(1)(D) applied and immediately thereafter 
distributed the stock of such new corporation or,
    (2) The net worth of the controlled corporation. (For this purpose 
the term net worth means the sum of the basis of all of the properties 
plus cash minus all liabilities.)

If the earnings and profits of the controlled corporation immediately 
before the transaction are less than the amount of the decrease in 
earnings and profits of the distributing corporation (including a case 
in which the controlled corporation has a deficit) the earnings and 
profits of the controlled corporation, after the transaction, shall be 
equal to the amount of such decrease. If the earnings and profits of the 
controlled corporation immediately before the transaction are more than 
the amount of the decrease in the earnings and profits of the 
distributing corporation, they shall remain unchanged.
    (c) In no case shall any part of a deficit of a distributing 
corporation within the meaning of section 355 be allocated to a 
controlled corporation.



Sec. 1.312-11  Effect on earnings and profits of certain other tax-free exchanges, 

tax-free distributions, and tax-free transfers from one corporation to 
          another.

    (a) If property is transferred by one corporation to another, and, 
under the law applicable to the year in which the transfer was made, no 
gain or loss was recognized (or was recognized only to the extent of the 
property received other than that permitted by such law to be received 
without the recognition of gain), then proper adjustment and allocation 
of the earnings and profits of the transferor shall be made as between 
the transferor and the transferee. Transfers to which the preceding 
sentence applies include contributions to capital, transfers under 
section 351, transfers in connection with reorganizations under section 
368, transfers in liquidations under section 332 and intercompany 
transfers during a period of affiliation. However, if, for example, 
property is transferred from one corporation to another in a transaction 
under section 351 or as a contribution to capital and the transfer is 
not followed or preceded by a reorganization, a transaction under 
section 302(a) involving a substantial part of the transferor's stock, 
or a total or partial liquidation, then ordinarily no allocation of the 
earnings and profits of the transferor shall be made. For specific rules 
as to allocation of earnings and profits in certain reorganizations 
under section 368 and in certain liquidations under section 332 see 
section 381 and the regulations thereunder. For allocation of earnings 
and profits in certain corporate separations see section 312(i) and 
Sec. 1.312-10.
    (b) The general rule provided in section 316 that every distribution 
is made out of earnings or profits to the extent thereof and from the 
most recently accumulated earnings or profits does not apply to:
    (1) The distribution, in pursuance of a plan of reorganization, by 
or on behalf of a corporation a party to the reorganization, or in a 
transaction subject to section 355, to its shareholders--
    (i) Of stock or securities in such corporation or in another 
corporation a party to the reorganization in any taxable year beginning 
before January 1, 1934, without the surrender by the distributees of 
stock or securities in such corporation (see section 112(g) of the 
Revenue Act of 1932 (47 Stat. 197)); or
    (ii) Of stock (other than preferred stock) in another corporation 
which is a party to the reorganization without the surrender by the 
distributees of stock in the distributing corporation if the 
distribution occurs after October 20, 1951, and is subject to section 
112(b)(11) of the Internal Revenue Code of 1939; or
    (iii) Of stock or securities in such corporation or in another 
corporation a party to the reorganization in any taxable year beginning 
before January 1,

[[Page 58]]

1939, or on or after such date, in exchange for its stock or securities 
in a transaction to which section 112(b)(3) of the Internal Revenue Code 
of 1939 was applicable; or
    (iv) Of stock or securities in such corporation or in another 
corporation in exchange for its stock or securities in a transaction 
subject to section 354 or 355,

if no gain to the distributees from the receipt of such stock or 
securities was recognized by law.
    (2) The distribution in any taxable year (beginning before January 
1, 1939, or on or after such date) of stock or securities, or other 
property or money, to a corporation in complete liquidation of another 
corporation, under the circumstances described in section 112(b)(6) of 
the Revenue Act of 1936 (49 Stat. 1679), the Revenue Act of 1938 (52 
Stat. 485), of the Internal Revenue Code of 1939, or section 332 of the 
Internal Revenue Code of 1954.
    (3) The distribution in any taxable year (beginning after December 
31, 1938), of stock or securities, or other property or money, in the 
case of an exchange or distribution described in section 371 of the 
Internal Revenue Code of 1939 or in section 1081 of the Internal Revenue 
Code of 1954 (relating to exchanges and distributions in obedience to 
orders of the Securities and Exchange Commission), if no gain to the 
distributee from the receipt of such stock, securities, or other 
property or money was recognized by law.
    (4) A stock dividend which was not subject to tax in the hands of 
the distributee because either it did not constitute income to him 
within the meaning of the sixteenth amendment to the Constitution or 
because exempt to him under section 115(f) of the Revenue Act of 1934 
(48 Stat. 712) or a corresponding provision of a prior Revenue Act, or 
section 305 of the Code.
    (5) The distribution, in a taxable year of the distributee beginning 
after December 31, 1931, by or on behalf of an insolvent corporation, in 
connection with a section 112(b)(10) reorganization under the Internal 
Revenue Code of 1939, or in a transaction subject to section 371 of the 
Internal Revenue Code of 1954, of stock or securities in a corporation 
organized or made use of to effectuate the plan of reorganization, if 
under section 112(e) of the Internal Revenue Code of 1939 or section 371 
of the Internal Revenue Code of 1954 no gain to the distributee from the 
receipt of such stock or securities was recognized by law.
    (c) A distribution described in paragraph (b) of this section does 
not diminish the earnings or profits of any corporation. In such cases, 
the earnings or profits remain intact and available for distribution as 
dividends by the corporation making such distribution, or by another 
corporation to which the earnings or profits are transferred upon such 
reorganization or other exchange. In the case, however, of amounts 
distributed in liquidation (other than a taxfree liquidation or 
reorganization described in paragraph (b)(1), (2), (3), or (5) of this 
section) the earnings or profits of the corporation making the 
distribution are diminished by the portion of such distribution properly 
chargeable to earnings or profits accumulated after February 28, 1913, 
after first deducting from the amount of such distribution the portion 
thereof allocable to capital account.
    (d) For the purposes of this section, the terms reorganization and 
party to the reorganization shall, for any taxable year beginning before 
January 1, 1934, have the meanings assigned to such terms in section 112 
of the Revenue Act of 1932 (47 Stat. 196); for any taxable year 
beginning after December 31, 1933, and before January 1, 1936, have the 
meanings assigned to such terms in section 112 of the Revenue Act of 
1934 (48 Stat. 704); for any taxable year beginning after December 31, 
1935, and before January 1, 1938, have the meanings assigned to such 
terms in section 112 of the Revenue Act of 1936 (49 Stat. 1678); for any 
taxable year beginning after December 31, 1937, and before January 1, 
1939, have the meanings assigned to such terms in section 112 of the 
Revenue Act of 1938 (52 Stat. 485); and for any taxable year beginning 
after December 31, 1938, and ending before June 22, 1954, providing no 
election is made under section 393(b)(2) of the Internal Revenue Code of 
1954, have the meanings assigned to such terms in section

[[Page 59]]

112(g)(1) of the Internal Revenue Code of 1939.



Sec. 1.312-12  Distributions of proceeds of loans guaranteed by the United States.

    (a) The provisions of section 312(j) are applicable with respect to 
a loan, any portion of which is guaranteed by an agency of the United 
States Government without regard to the percentage of such loan subject 
to such guarantee.
    (b) The application of section 312(j) is illustrated by the 
following example:

    Example. Corporation A borrowed $1,000,000 for the purpose of 
construction of an apartment house, the cost and adjusted basis of which 
was $900,000. This loan was guaranteed by an agency of the United States 
Government. One year after such loan was made and after the completion 
of construction of the building (but before such corporation had 
received any income) it distributed $100,000 cash to its shareholders. 
The earnings and profits of the taxable year of such corporation are 
increased (pursuant to section 312(j)) by $100,000 immediately prior to 
such distribution and are decreased by $100,000 immediately after such 
distribution. Such decrease, however, does not reduce the earnings and 
profits below zero. Two years later, it has no accumulated earnings and 
has earnings of the taxable year of $100,000. Before it has made any 
payments on the loan, it distributes $200,000 to its shareholders. The 
earnings and profits of the taxable year of the corporation ($100,000) 
are increased by $100,000, the excess of the amount of the guaranteed 
loan over the adjusted basis of the apartment house (calculated without 
adjustment for depreciation). The entire amount of each distribution is 
treated as a distribution out of earnings and profits and, accordingly, 
as a taxable dividend.



Sec. 1.312-15  Effect of depreciation on earnings and profits.

    (a) Depreciation for taxable years beginning after June 30, 1972--
(1) In general. Except as provided in subparagraph (2) of this paragraph 
and paragraph (c) of this section, for purposes of computing the 
earnings and profits of a corporation (including a real estate 
investment trust as defined in section 856) for any taxable year 
beginning after June 30, 1972, the allowance for depreciation (and 
amortization, if any) shall be deemed to be the amount which would be 
allowable for such year if the straight line method of depreciation had 
been used for all property for which depreciation is allowable for each 
taxable year beginning after June 30, 1972. Thus, for taxable years 
beginning after June 30, 1972, in determining the earnings and profits 
of a corporation, depreciation must be computed under the straight line 
method, notwithstanding that in determining taxable income the 
corporation uses an accelerated method of depreciation described in 
subparagraph (A), (B), or (C) of section 312(m)(2) or elects to amortize 
the basis of property under section 169, 184, 187, or 188, or any 
similar provision. See Sec. 1.168(k)-1(f)(7) with respect to the 
treatment of the additional first year depreciation deduction allowable 
under section 168(k) for qualified property or 50-percent bonus 
depreciation property, and Sec. 1.1400L(b)-1(f)(7) with respect to the 
treatment of the additional first year depreciation deduction allowable 
under section 1400L(b) for qualified New York Liberty Zone property, for 
purposes of computing the earnings and profits of a corporation.
    (2) Exception. (i) If, for any taxable year beginning after June 30, 
1972, a method of depreciation is used by a corporation in computing 
taxable income which the Secretary or his delegate has determined 
results in a reasonable allowance under section 167(a) and which is not 
a declining balance method of depreciation (described in Sec. 1.167(b)-
2), the sum of the years-digits method (described in Sec. 1.167(b)-3), 
or any other method allowed solely by reason of the application of 
subsection (b)(4) or (j)(1)(C) of section 167, then the adjustment to 
earnings and profits for depreciation for such year shall be determined 
under the method so used (in lieu of the straight line method).
    (ii) The Commissioner has determined that the ``unit of production'' 
(see Sec. 1.167(b)-0(b)), and the ``machine hour'' methods of 
depreciation, when properly used under appropriate circumstances, meet 
the requirements of subdivision (i) of this subparagraph. Thus, the 
adjustment to earnings and profits for depreciation (for the taxable 
year for which either of such methods is properly used under appropriate 
circumstances) shall be determined under whichever of such methods is 
used to compute taxable income.

[[Page 60]]

    (3) Determinations under straight line method. (i) In the case of 
property with respect to which an allowance for depreciation is claimed 
in computing taxable income, the determination of the amount which would 
be allowable under the straight line method shall be based on the manner 
in which the corporation computes depreciation in determining taxable 
income. Thus, if an election under Sec. 1.167(a)-11 is in effect with 
respect to the property, the amount of depreciation which would be 
allowable under the straight line method shall be determined under Sec. 
1.167(a)-11(g)(3). On the other hand, if property is not depreciated 
under the provisions of Sec. 1.167(a)-11, the amount of depreciation 
which would be allowable under the straight line method shall be 
determined under Sec. 1.167(b)-1. Any election made under section 
167(f), with respect to reducing the amount of salvage value taken into 
account in computing the depreciation allowance for certain property, or 
any convention adopted under Sec. 1.167(a)-10(b) or Sec. 1.167(a)-
11(c)(2), with respect to additions and retirements from multiple asset 
accounts, which is used in computing depreciation for taxable income 
shall be used in computing depreciation for earnings and profits 
purposes.
    (ii) In the case of property with respect to which an election to 
amortize is in effect under section 169, 184, 187, or 188, or any 
similar provision, the amount which would be allowable under the 
straight line method of depreciation shall be determined under the 
provisions of Sec. 1.167(b)-1. Thus, the cost or other basis of the 
property, less its estimated salvage value, is to be deducted in equal 
annual amounts over the period of the estimated useful life of the 
property. In computing the amount of depreciation for earnings and 
profits purposes, a taxpayer may utilize the provisions of section 
167(f) (relating to the reduction in the amount of salvage value taken 
into account in computing the depreciation allowance for certain 
property) and any convention which could have been adopted for such 
property under Sec. 1.167(a)-10(b) (relating to additions and 
retirements from multiple asset accounts).
    (b) Transitional rules--(1) Depreciation. If, for the taxable year 
which includes June 30, 1972, (i) the allowance for depreciation of any 
property is computed under a method other than the straight line method 
or a method described in paragraph (a)(2) of this section, and (ii) 
paragraph (a)(1) of this section applies to such property for the first 
taxable year beginning after June 30, 1972, then adjustments to earnings 
and profits for depreciation of such property for taxable years 
beginning after June 30, 1972, shall be determined as if the corporation 
changed to the straight line method with respect to such property as of 
the first day of the first taxable year beginning after June 30, 1972. 
Thus, if an election under Sec. 1.167 (a)-11 is in effect with respect 
to the property, the change shall be made under the provisions of Sec. 
1.167(a)-11(c)(1)(iii), except that no statement setting forth the 
vintage accounts for which the change is made shall be furnished with 
the income tax return of the year of change if the change is only for 
purposes of computing earnings and profits. In all other cases, the 
unrecovered cost or other basis of the property (less a reasonable 
estimate for salvage) as of such first day shall be recovered through 
equal annual allowances over the estimated remaining useful life 
determined in accordance with the circumstances existing at that time. 
See paragraph (a)(3)(i) of this section for rules relating to the 
applicability of section 167(f) in determining salvage value.
    (2) Amortization. If, for the taxable year which includes June 30, 
1972, the basis of any property is amortized under section 169, 184, 
187, or 188, or any similar provision, then adjustments to earnings and 
profits for depreciation or amortization of such property for taxable 
years beginning after June 30, 1972, shall be determined as if the 
unrecovered cost or other basis of the property (less a reasonable 
estimate for salvage) as of the first day of the first taxable year 
beginning after June 30, 1972, were recovered through equal annual 
allowances over the estimated remaining useful life of the property 
determined in accordance with the circumstances existing at that time. 
See paragraph (a)(3)(ii) of this section for

[[Page 61]]

rules relating to the applicability of section 167(f).
    (c) Certain foreign corporations. Paragraphs (a) and (b) of this 
section shall not apply in computing the earnings and profits of a 
foreign corporation for any taxable year for which less than 20 percent 
of the gross income from all sources of such corporation is derived from 
sources within the United States.
    (d) Books and records. Wherever different methods of depreciation 
are used for taxable income and earnings and profits purposes, records 
shall be maintained which show the depreciation taken for earnings and 
profits purposes each year and which will allow computation of the 
adjusted basis of the property in each account using the depreciation 
taken for earnings and profits purposes.

[T.D. 7221, 37 FR 24746, Nov. 21, 1972, as amended by T.D. 9283, 71 FR 
51746, Aug. 31, 2006]

              definitions; constructive ownership of stock



Sec. 1.316-1  Dividends.

    (a)(1) The term dividend for the purpose of subtitle A of the Code 
(except when used in subchapter L, chapter 1 of the Code, in any case 
where the reference is to dividends and similar distributions of 
insurance companies paid to policyholders as such) comprises any 
distribution of property as defined in section 317 in the ordinary 
course of business, even though extraordinary in amount, made by a 
domestic or foreign corporation to its shareholders out of either--
    (i) Earnings and profits accumulated since February 28, 1913, or
    (ii) Earnings and profits of the taxable year computed without 
regard to the amount of the earnings and profits (whether of such year 
or accumulated since February 28, 1913) at the time the distribution was 
made.

The earnings and profits of the taxable year shall be computed as of the 
close of such year, without diminution by reason of any distributions 
made during the taxable year. For the purpose of determining whether a 
distribution constitutes a dividend, it is unnecessary to ascertain the 
amount of the earnings and profits accumulated since February 28, 1913, 
if the earnings and profits of the taxable year are equal to or in 
excess of the total amount of the distributions made within such year.
    (2) Where a corporation distributes property to its shareholders on 
or after June 22, 1954, the amount of the distribution which is a 
dividend to them may not exceed the earnings and profits of the 
distributing corporation.
    (3) The rule of (2) above may be illustrated by the following 
example:

    Example. X and Y, individuals, each own one-half of the stock of 
Corporation A which has earnings and profits of $10,000. Corporation A 
distributes property having a basis of $6,000 and a fair market value of 
$16,000 to its shareholders, each shareholder receiving property with a 
basis of $3,000 and with a fair market value of $8,000 in a distribution 
to which section 301 applies. The amount taxable to each shareholder as 
a dividend under section 301(c) is $5,000.

    (b)(1) In the case of a corporation which, under the law applicable 
to the taxable year in which a distribution is made, is a personal 
holding company or which, for the taxable year in respect of which a 
distribution is made under section 563 (relating to dividends paid 
within 2 1/2 months after the close of the taxable year), or section 547 
(relating to deficiency dividends), or corresponding provisions of a 
prior income tax law, was under the applicable law a personal holding 
company, the term dividend, in addition to the meaning set forth in the 
first sentence of section 316, also means a distribution to its 
shareholders as follows: A distribution within a taxable year of the 
corporation, or of a shareholder, is a dividend to the extent of the 
corporation's undistributed personal holding company income (determined 
under section 545 without regard to distributions under section 
316(b)(2)) for the taxable year in which, or, in the case of a 
distribution under section 563 or section 547, the taxable year in 
respect of which, the distribution was made. This subparagraph does not 
apply to distributions in partial or complete liquidation of a personal 
holding company. In the case of certain complete liquidations of a 
personal holding company see subparagraph (2) of this paragraph.
    (2) In the case of a corporation which, under the law applicable to 
the taxable

[[Page 62]]

year in which a distribution is made, is a personal holding company or 
which, for the taxable year in respect of which a distribution is made 
under section 563, or section 547, or corresponding provisions of a 
prior income tax law, was under the applicable law a personal holding 
company, the term dividend, in addition to the meaning set forth in the 
first sentence of section 316, also means, in the case of a complete 
liquidation occurring within 24 months after the adoption of a plan of 
liquidation, a distribution of property to its shareholders within such 
period, but--
    (i) Only to the extent of the amounts distributed to distributees 
other than corporate shareholders, and
    (ii) Only to the extent that the corporation designates such amounts 
as a dividend distribution and duly notifies such distributees in 
accordance with subparagraph (5) of this paragraph, but
    (iii) Not in excess of the sum of such distributees' allocable share 
of the undistributed personal holding company income for such year 
(determined under section 545 without regard to sections 562(b) and 
316(b)(2)(B)).

Section 316(b)(2)(B) and this subparagraph apply only to distributions 
made in any taxable year of the distributing corporation beginning after 
December 31, 1963. The amount designated with respect to a noncorporate 
distributee may not exceed the amount actually distributed to such 
distributee. For purposes of determining a noncorporate distributee's 
gain or loss on liquidation, amounts distributed in complete liquidation 
to such distributee during a taxable year are reduced by the amounts 
designated as a dividend with respect to such distributee for such year. 
For purposes of section 333(e)(1), a shareholder's ratable share of the 
earnings and profits of the corporation accumulated after February 28, 
1913, shall be reduced by the amounts designated as a dividend with 
respect to such shareholder (even though such designated amounts are 
distributed during the 1-month period referred to in section 333).
    (3) For purposes of subparagraph (2)(iii) of this paragraph--
    (i) Except as provided in subdivision (ii) of this subparagraph, the 
sum of the noncorporate distributees' allocable share of undistributed 
personal holding company income for the taxable year in which, or in 
respect of which, the distribution was made (computed without regard to 
sections 562(b) and 316(b)(2)(B)) shall be determined by multiplying 
such undistributed personal holding company income by the ratio which 
the aggregate value of the stock held by all noncorporate shareholders 
immediately before the record date of the last liquidating distribution 
in such year bears to the total value of all stock outstanding on such 
date. For rules applicable in a case where the distributing corporation 
has more than one class of stock, see subdivision (iii) of this 
subparagraph.
    (ii) If more than one liquidating distribution was made during the 
year, and if, after the record date of the first distribution but before 
the record date of the last distribution, there was a change in the 
relative shareholdings as between noncorporate shareholders and 
corporate shareholders, then the sum of the noncorporate distributees' 
allocable share of undistributed personal holding company income for the 
taxable year in which, or in respect of which, the distributions were 
made (computed without regard to sections 562(b) and 316(b)(2)(B)) shall 
be determined as follows:
    (a) First, allocate the corporation's undistributed personal holding 
company income among the distributions made during the taxable year by 
reference to the ratio which the aggregate amount of each distribution 
bears to the total amount of all distributions during such year;
    (b) Second, determine the noncorporate distributees' allocable share 
of the corporation's undistributed personal holding company income for 
each distribution by multiplying the amount determined under (a) of this 
subdivision (ii) for each distribution by the ratio which the aggregate 
value of the stock held by all noncorporate shareholders immediately 
before the record date of such distribution bears to the total value of 
all stock outstanding on such date; and
    (c) Last, determine the sum of the noncorporate distributees' 
allocable

[[Page 63]]

share of the corporation's undistributed personal holding company income 
for all such distributions.

For rules applicable in a case where the distributing corporation has 
more than one class of stock, see subdivision (iii) of this 
subparagraph.
    (iii) Where the distributing corporation has more than one class of 
stock--
    (a) The undistributed personal holding company income for the 
taxable year in which, or in respect of which the distribution was made 
shall be treated as a fund from which dividends may properly be paid and 
shall be allocated between or among the classes of stock in a manner 
consistent with the dividend rights of such classes under local law and 
the pertinent governing instruments, such as, for example, the 
distributing corporation's articles or certificate of incorporation and 
bylaws;
    (b) The noncorporate distributees' allocable share of the 
undistributed personal holding company income for each class of stock 
shall be determined separately in accordance with the rules set forth in 
subdivisions (i) or (ii) of this subparagraph, as if each class of stock 
were the only class of stock outstanding; and
    (c) The sum of the noncorporate distributees' allocable share of the 
undistributed personal holding company income for the taxable year in 
which, or in respect of which, the distribution was made shall be the 
sum of the noncorporate distributees' allocable share of the 
undistributed personal holding company income for all classes of stock.
    (iv) For purposes of this subparagraph, in any case where the record 
date of a liquidating distribution cannot be ascertained, the record 
date of the distribution shall be the date on which the liquidating 
distribution was actually made.
    (4) The amount designated as a dividend to a noncorporate 
distributee for any taxable year of the distributing corporation may not 
exceed an amount equal to the sum of the noncorporate distributees' 
allocable share of undistributed personal holding company income (as 
determined under subparagraph (3) of this paragraph) for such year 
multiplied by the ratio which the aggregate value of the stock held by 
such distributee immediately before the record date of the liquidating 
distribution or, if the record date cannot be ascertained, immediately 
before the date on which the liquidating distribution was actually made, 
bears to the aggregate value of stock outstanding held by all 
noncorporate distributees on such date. In any case where more than one 
liquidating distribution is made during the taxable year, the aggregate 
amount which may be designated as a dividend to a noncorporate 
distributee for such year may not exceed the aggregate of the amounts 
determined by applying the principle of the preceding sentence to the 
amounts determined under subparagraphs (3)(ii)(a) and (b) of this 
paragraph for each distribution. Where the distributing corporation has 
more than one class of stock, the limitation on the amount which may be 
designated as a dividend to a noncorporate distributee for any taxable 
year shall be determined by applying the rules of this subparagraph 
separately with respect to the noncorporate distributees' allocable 
share of the undistributed personal holding company income for each 
class of stock (as determined under subparagraphs (3)(iii)(a) and (b) of 
this paragraph).
    (5) A corporation may designate as a dividend to a shareholder all 
or part of a distribution in complete liquidation described in section 
316(b)(2)(B) of this paragraph by:
    (i) Claiming a dividends paid deduction for such amount in its 
return for the year in which, or in respect of which, the distribution 
is made,
    (ii) Including such amount as a dividend in Form 1099 filed in 
respect of such shareholder pursuant to section 6042(a) and the 
regulations thereunder and in a written statement of dividend payments 
furnished to such shareholder pursuant to section 6042(c) and Sec. 
1.6042-4, and
    (iii) Indicating on the written statement of dividend payments 
furnished to such shareholder the amount included in such statement 
which is designated as a dividend under section 316(b)(2)(B) and this 
paragraph.

If a corporation complies with the procedure prescribed in the preceding 
sentence, it satisfies both the designation

[[Page 64]]

and notification requirements of section 316(b)(2)(B)(ii) and paragraph 
(b)(2)(ii) of this section. An amount designated as a dividend shall not 
be included as a distribution in liquidation on Form 1099L filed 
pursuant to Sec. 1.6043-2 (relating to returns of information 
respecting distributions in liquidation). If a corporation designates a 
dividend in accordance with this subparagraph, it shall attach to the 
return in which it claims a deduction for such designated dividend a 
schedule indicating all facts necessary to determine the sum of the 
noncorporate distributees' allocable share of undistributed personal 
holding company income (determined in accordance with subparagraph (3) 
of this paragraph) for the year in which, or in respect of which, the 
distribution is made.
    (c) Except as provided in section 316(b)(1), the term dividend 
includes any distribution of property to shareholders to the extent made 
out of accumulated or current earnings and profits. See, however, 
section 331 (relating to distributions in complete or partial 
liquidation), section 301(e) (relating to distributions by personal 
service corporations), section 302(b) (relating to redemptions treated 
as amounts received from the sale or exchange of stock), and section 303 
(relating to distributions in redemption of stock to pay death taxes). 
See also section 305(b) for certain distributions of stock or stock 
rights treated as distributions of property.
    (d) In the case of a corporation which, under the law applicable to 
the taxable year in respect of which a distribution is made under 
section 860 (relating to deficiency dividends), was a regulated 
investment company (within the meaning of section 851), or a real estate 
investment trust (within the meaning of section 856), the term dividend, 
in addition to the meaning set forth in paragraphs (a) and (b) of 
section 316, means a distribution of property to its shareholders which 
constitutes a ``deficiency dividend'' as defined in section 860(f).
    (e) The application of section 316 may be illustrated by the 
following examples:

    Example 1. At the beginning of the calendar year 1955, Corporation M 
had an operating deficit of $200,000 and the earnings and profits for 
the year amounted to $100,000. Beginning on March 16, 1955, the 
corporation made quarterly distributions of $25,000 during the taxable 
year to its shareholders. Each distribution is a taxable dividend in 
full, irrespective of the actual or the pro rata amount of the earnings 
and profits on hand at any of the dates of distribution, since the total 
distributions made during the year ($100,000) did not exceed the total 
earnings and profits of the year ($100,000).
    Example 2. At the beginning of the calendar year 1955, Corporation 
N, a personal holding company, had no accumulated earnings and profits. 
During that year it made no earnings and profits but, due to the 
disallowance of certain deductions, its undistributed personal holding 
company income (determined under section 545 without regard to 
distributions under section 316(b)(2)) was $16,000. It distributed to 
shareholders on December 15, 1955, $15,000, and on February 1, 1956, 
$1,000, the latter amount being claimed as a deduction under section 563 
in its personal holding company schedule for 1955 filed with its return 
for 1955 on March 15, 1956. Both distributions are taxable dividends in 
full, since they do not exceed the undistributed personal holding 
company income (determined without regard to such distributions) for 
1955, the taxable year in which the distribution of $15,000 was made and 
with respect to which the distribution of $1,000 was made. It is 
immaterial whether Corporation N is a personal holding company for the 
taxable year 1956 or whether it had any income for that year.
    Example 3. In 1959, a deficiency in personal holding company tax was 
established against Corporation O for the taxable year 1955 in the 
amount of $35,500 based on an undistributed personal holding company 
income of $42,000. Corporation O complied with the provisions of section 
547 and in December 1959 distributed $42,000 to its stockholders as 
``deficiency dividends.'' The distribution of $42,000 is a taxable 
dividend since it does not exceed $42,000 (the undistributed personal 
holding company income for 1955, the taxable year with respect to which 
the distribution was made). It is immaterial whether Corporation O is a 
personal holding company for the taxable year 1959 or whether it had any 
income for that year.
    Example 4. At the beginning of the taxable year 1955, Corporation P, 
a personal holding company, had a deficit in earnings and profits of 
$200,000. During that year it made earnings and profits of $90,000. For 
that year, however, it had an undistributed personal holding income 
(determined under section 545 without regard to distributions under 
section 316(b)(2)) of $80,000. During such taxable year it distributed 
to its shareholders $100,000. The distribution of $100,000 is a taxable 
dividend to the extent of $90,000 since its

[[Page 65]]

earnings and profits for that year, $90,000, exceed $80,000, the 
undistributed personal holding company income determined without regard 
to such distribution.
    Example 5. Corporation O, a calendar year taxpayer, is completely 
liquidated on December 31, 1964, pursuant to a plan of liquidation 
adopted July 1, 1964. No distributions in liquidation were made pursuant 
to the plan of liquidation adopted July 1, 1964, until the distribution 
in complete liquidation on December 31, 1964. Corporation O has 
undistributed personal holding company income of $300,000 for the year 
1964 (computed without regard to section 562(b) or section 
316(b)(2)(B)). On December 31, 1964, immediately before the record date 
of the distribution in complete liquidation, individual A owns 200 
shares of Corporation O's outstanding stock and Corporation P owns the 
remaining 100 shares of outstanding stock. All shares are equal in 
value. The noncorporate distributees' allocable share of undistributed 
personal holding company income for 1964 is $200,000

200 shares/300 sharesx$300,000.


If at least $200,000 is distributed to A in the liquidation, then 
Corporation O may designate $200,000 to A as a dividend in accordance 
with paragraph (b)(5) of this section, and, if such amount is 
designated, then A must treat $200,000 as a dividend to which section 
301 applies. For an example of the treatment of the distribution to 
Corporation P see paragraph (b)(2)(iii) of Sec. 1.562-1.
    Example 6. Corporation Q, a calendar year taxpayer, is completely 
liquidated on December 31, 1964, pursuant to a plan of liquidation 
adopted July 1, 1964. No distributions in liquidation were made pursuant 
to the plan of liquidation adopted July 1, 1964, until the distribution 
in complete liquidation on December 31, 1964. Corporation Q has 
undistributed personal holding company income of $40,000 for the year 
1964 (computed without regard to section 562(b) or section 
316(b)(2)(B)). On December 31, 1964, immediately before the record date 
of the distribution in complete liquidation, Corporation Q has 
outstanding 300 shares of common stock and 100 shares of noncumulative 
preferred stock. Corporation Q's articles of incorporation provide that 
the preferred stock is entitled to dividends of $10 per share per year. 
Of Corporation Q's stock, individual B owns 200 shares of the common 
stock and 50 shares of the preferred stock, and Corporation R owns all 
remaining shares. All of the common shares are equal in value, and all 
of the preferred shares are equal in value. No dividends had been paid 
on the preferred stock during the year 1964. Of the $40,000 of 
undistributed personal holding company income, $1,000 must be allocated 
to the preferred stock because of the rights of the holders of such 
stock, under Q's articles of incorporation, to receive that amount in 
dividends for the year 1964. The noncorporate distributees' allocable 
share of undistributed personal holding company income for 1964 is 
$26,500.

50 preferred shares/100 preferred sharesx$1,000+200 common shares / 300 
common sharesx$39,000


If at least $26,500 is distributed to B in the liquidation, then 
corporation Q may designate $26,500 to B as a dividend in accordance 
with paragraph (b)(5) of this section, and, if such amount is 
designated, then B must treat $26,500 as a dividend to which section 301 
applies.
    Example 7. In 1979, a deficiency of $46,000 in the tax on real 
estate investment trust taxable income is established against 
corporation R for the taxable year 1977, based on an increase in real 
estate investment trust taxable income of $100,000. Corporation R 
complied with the provisions of section 860 and in December 1979 
distributed to its stockholders $100,000, which qualified as 
``deficiency dividends'' under section 860. The distribution of $100,000 
is a taxable dividend. It is immaterial whether corporation R is a real 
estate investment trust for the taxable year 1979 or whether it had 
accumulated or current earnings and profits in 1979. See section 
316(b)(3).

(Sec. 860(l) (92 Stat. 2849, 26 U.S.C. 860(l)); sec. 860(g) (92 Stat. 
2850, 26 U.S.C. 860(g)); and sec. 7805 (68A Stat. 917, 26 U.S.C. 7805))

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6625, 27 FR 
12541, Dec. 19, 1962; T.D. 6949, 33 FR 5519, Apr. 9, 1968; T.D. 7767, 46 
FR 11264, Feb. 6, 1981; T.D. 7936, 49 FR 2105, Jan. 18, 1984]



Sec. 1.316-2  Sources of distribution in general.

    (a) For the purpose of income taxation every distribution made by a 
corporation is made out of earnings and profits to the extent thereof 
and from the most recently accumulated earnings and profits. In 
determining the source of a distribution, consideration should be given 
first, to the earnings and profits of the taxable year; second, to the 
earnings and profits accumulated since February 28, 1913, only in the 
case where, and to the extent that, the distributions made during the 
taxable year are not regarded as out of the earnings and profits of that 
year; third, to the earnings and profits accumulated before March 1, 
1913, only after all the earnings and profits of the taxable year and 
all the earnings and profits accumulated since February 28, 1913, have 
been distributed; and, fourth,

[[Page 66]]

to sources other than earnings and profits only after the earnings and 
profits have been distributed.
    (b) If the earnings and profits of the taxable year (computed as of 
the close of the year without diminution by reason of any distributions 
made during the year and without regard to the amount of earnings and 
profits at the time of the distribution) are sufficient in amount to 
cover all the distributions made during that year, then each 
distribution is a taxable dividend. See Sec. 1.316-1. If the 
distributions made during the taxable year consist only of money and 
exceed the earnings and profits of such year, then that proportion of 
each distribution which the total of the earnings and profits of the 
year bears to the total distributions made during the year shall be 
regarded as out of the earnings and profits of that year. The portion of 
each such distribution which is not regarded as out of earnings and 
profits of the taxable year shall be considered a taxable dividend to 
the extent of the earnings and profits accumulated since February 28, 
1913, and available on the date of the distribution. In any case in 
which it is necessary to determine the amount of earnings and profits 
accumulated since February 28, 1913, and the actual earnings and profits 
to the date of a distribution within any taxable year (whether beginning 
before January 1, 1936, or, in the case of an operating deficit, on or 
after that date) cannot be shown, the earnings and profits for the year 
(or accounting period, if less than a year) in which the distribution 
was made shall be prorated to the date of the distribution not counting 
the date on which the distribution was made.
    (c) The provisions of the section may be illustrated by the 
following example:

    Example. At the beginning of the calendar year 1955, Corporation M 
had $12,000 in earnings and profits accumulated since February 28, 1913. 
Its earnings and profits for 1955 amounted to $30,000. During the year 
it made quarterly cash distributions of $15,000 each. Of each of the 
four distributions made, $7,500 (that portion of $15,000 which the 
amount of $30,000, the total earnings and profits of the taxable year, 
bears to $60,000, the total distributions made during the year) was paid 
out of the earnings and profits of the taxable year; and of the first 
and second distributions, $7,500 and $4,500, respectively, were paid out 
of the earnings and profits accumulated after February 28, 1913, and 
before the taxable year, as follows:

----------------------------------------------------------------------------------------------------------------
                         Distributions during 1955                            Portion  Portion out
----------------------------------------------------------------------------  out of   of earnings
                                                                             earnings  accumulated
                                                                                and     since Feb.  Taxable amt.
                                                                              profits   28, 1913,      of each
                               Date                                 Amount    of the    and before  distribution
                                                                              taxable  the taxable
                                                                               year        year
----------------------------------------------------------------------------------------------------------------
March 10.........................................................   $15,000    $7,500      $7,500      $15,000
June 10..........................................................    15,000     7,500       4,500       12,000
September 10.....................................................    15,000     7,500  ...........       7,500
December 10......................................................    15,000     7,500  ...........       7,500
                                                                  ----------------------------------------------
  Total amount taxable as dividends..............................  ........  ........  ...........      42,000
----------------------------------------------------------------------------------------------------------------


    (d) Any distribution by a corporation out of earnings and profits 
accumulated before March 1, 1913, or out of increase in value of 
property accrued before March 1, 1913 (whether or not realized by sale 
or other disposition, and, if realized, whether before, on, or after 
March 1, 1913), is not a dividend within the meaning of subtitle A of 
the Code.
    (e) A reserve set up out of gross income by a corporation and 
maintained for the purpose of making good any loss of capital assets on 
account of depletion or depreciation is not a part of surplus out of 
which ordinary dividends may be paid. A distribution made from a 
depletion or a depreciation reserve based upon the cost or other basis 
of the property will not be considered as having been paid out of 
earnings and profits, but the amount thereof shall be applied against 
and reduce the cost or other basis of the stock upon which declared. If 
such a distribution is in excess of the basis, the excess shall be taxed 
as a gain from the sale or other disposition of property as provided in 
section 301(c)(3)(A). A distribution from a depletion reserve based upon 
discovery value to the extent that such reserve represents the excess of 
the discovery value over the cost or other basis for determining gain or 
loss, is, when received by the shareholders, taxable as an ordinary 
dividend. The amount by which a corporation's percentage depletion 
allowance for any year exceeds depletion sustained on

[[Page 67]]

cost or other basis, that is, determined without regard to discovery or 
percentage depletion allowances for the year of distribution or prior 
years, constitutes a part of the corporation's ``earnings and profits 
accumulated after February 28, 1913,'' within the meaning of section 
316, and, upon distribution to shareholders, is taxable to them as a 
dividend. A distribution made from that portion of a depletion reserve 
based upon a valuation as of March 1, 1913, which is in excess of the 
depletion reserve based upon cost, will not be considered as having been 
paid out of earnings and profits, but the amount of the distribution 
shall be applied against and reduce the cost or other basis of the stock 
upon which declared. See section 301. No distribution, however, can be 
made from such a reserve until all the earnings and profits of the 
corporation have first been distributed.



Sec. 1.317-1  Property defined.

    The term property, for purposes of part 1, subchapter C, chapter 1 
of the Code, means any property (including money, securities, and 
indebtedness to the corporation) other than stock, or rights to acquire 
stock, in the corporation making the distribution.



Sec. 1.318-1  Constructive ownership of stock; introduction.

    (a) For the purposes of certain provisions of chapter 1 of the Code, 
section 318(a) provides that stock owned by a taxpayer includes stock 
constructively owned by such taxpayer under the rules set forth in such 
section. An individual is considered to own the stock owned, directly or 
indirectly, by or for his spouse (other than a spouse who is legally 
separated from the individual under a decree of divorce or separate 
maintenance), and by or for his children, grandchildren, and parents. 
Under section 318(a)(2) and (3), constructive ownership rules are 
established for partnerships and partners, estates and beneficiaries, 
trusts and beneficiaries, and corporations and stockholders. If any 
person has an option to acquire stock, such stock is considered as owned 
by such person. The term option includes an option to acquire such an 
option and each of a series of such options.
    (b) In applying section 318(a) to determine the stock ownership of 
any person for any one purpose--
    (1) A corporation shall not be considered to own its own stock by 
reason of section 318(a)(3)(C);
    (2) In any case in which an amount of stock owned by any person may 
be included in the computation more than one time, such stock shall be 
included only once, in the manner in which it will impute to the person 
concerned the largest total stock ownership; and
    (3) In determining the 50-percent requirement of section 
318(a)(2)(C) and (3)(C), all of the stock owned actually and 
constructively by the person concerned shall be aggregated.

[T.D. 6969, 33 FR 11999, Aug. 23, 1968]



Sec. 1.318-2  Application of general rules.

    (a) The application of paragraph (b) of Sec. 1.318-1 may be 
illustrated by the following examples:

    Example 1. H, an individual, owns all of the stock of corporation A. 
Corporation A is not considered to own the stock owned by H in 
corporation A.
    Example 2. H, an individual, his wife, W, and his son, S, each own 
one-third of the stock of the Green Corporation. For purposes of 
determining the amount of stock owned by H, W, or S for purposes of 
section 318(a)(2)(C) and (3)(C), the amount of stock held by the other 
members of the family shall be added pursuant to paragraph (b)(3) of 
Sec. 1.318-1 in applying the 50-percent requirement of such section. H, 
W, or S, as the case may be, is for this purpose deemed to own 100 
percent of the stock of the Green Corporation.

    (b) The application of section 318(a)(1), relating to members of a 
family, may be illustrated by the following example:

    Example. An individual, H, his wife, W, his son, S, and his grandson 
(S's son), G, own the 100 outstanding shares of stock of a corporation, 
each owning 25 shares. H, W, and S are each considered as owning 100 
shares. G is considered as owning only 50 shares, that is, his own and 
his father's.

    (c) The application of section 318(a)(2) and (3), relating to 
partnerships, trusts and corporations, may be illustrated by the 
following examples:


[[Page 68]]


    Example 1. A, an individual, has a 50 percent interest in a 
partnership. The partnership owns 50 of the 100 outstanding shares of 
stock of a corporation, the remaining 50 shares being owned by A. The 
partnership is considered as owning 100 shares. A is considered as 
owning 75 shares.
    Example 2. A testamentary trust owns 25 of the outstanding 100 
shares of stock of a corporation. A, an individual, who holds a vested 
remainder in the trust having a value, computed actuarially equal to 4 
percent of the value of the trust property, owns the remaining 75 
shares. Since the interest of A in the trust is a vested interest rather 
than a contingent interest (whether or not remote), the trust is 
considered as owning 100 shares. A is considered as owning 76 shares.
    Example 3. The facts are the same as in (2), above, except that A's 
interest in the trust is a contingent remainder. A is considered as 
owning 76 shares. However, since A's interest in the trust is a remote 
contingent interest, the trust is not considered as owning any of the 
shares owned by A.
    Example 4. A and B, unrelated individuals, own 70 percent and 30 
percent, respectively, in value of the stock of Corporation M. 
Corporation M owns 50 of the 100 outstanding shares of stock of 
Corporation O, the remaining 50 shares being owned by A. Corporation M 
is considered as owning 100 shares of Corporation O, and A is considered 
as owning 85 shares.
    Example 5. A and B, unrelated individuals, own 70 percent and 30 
percent, respectively, of the stock of corporation M. A, B, and 
corporation M all own stock of corporation O. Since B owns less than 50 
percent in value of the stock of corporation M, neither B nor 
corporation M constructively owns the stock of corporation O owned by 
the other. However, for purposes of certain sections of the Code, such 
as sections 304 and 856(d), the 50-percent limitation of section 
318(a)(2)(C) and (3)(C) is disregarded or is reduced to less than 30 
percent. For such purposes, B constructively owns his proportionate 
share of the stock of corporation O owned directly by corporation M, and 
corporation M constructively owns the stock of corporation O owned by B.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6969, 33 FR 
11999, Aug. 23, 1968]



Sec. 1.318-3  Estates, trusts, and options.

    (a) For the purpose of applying section 318(a), relating to estates, 
property of a decedent shall be considered as owned by his estate if 
such property is subject to administration by the executor or 
administrator for the purpose of paying claims against the estate and 
expenses of administration notwithstanding that, under local law, legal 
title to such property vests in the decedent's heirs, legatees or 
devisees immediately upon death. The term beneficiary includes any 
person entitled to receive property of a decedent pursuant to a will or 
pursuant to laws of descent and distribution. A person shall no longer 
be considered a beneficiary of an estate when all the property to which 
he is entitled has been received by him, when he no longer has a claim 
against the estate arising out of having been a beneficiary, and when 
there is only a remote possibility that it will be necessary for the 
estate to seek the return of property or to seek payment from him by 
contribution or otherwise to satisfy claims against the estate or 
expenses of administration. When, pursuant to the preceding sentence, a 
person ceases to be a beneficiary, stock owned by him shall not 
thereafter be considered owned by the estate, and stock owned by the 
estate shall not thereafter be considered owned by him. The application 
of section 318(a) relating to estates may be illustrated by the 
following examples:

    Example 1. (a) A decedent's estate owns 50 of the 100 outstanding 
shares of stock of corporation X. The remaining shares are owned by 
three unrelated individuals, A, B, and C, who together own the entire 
interest in the estate. A owns 12 shares of stock of corporation X 
directly and is entitled to 50 percent of the estate. B owns 18 shares 
directly and has a life estate in the remaining 50 percent of the 
estate. C owns 20 shares directly and also owns the remainder interest 
after B's life estate.
    (b) If section 318(a)(5)(C) applies (see paragraph (c)(3) of Sec. 
1.318-4), the stock of corporation X is considered to be owned as 
follows: the estate is considered as owning 80 shares, 50 shares 
directly, 12 shares constructively through A, and 18 shares 
constructively through B; A is considered as owning 37 shares, 12 shares 
directly, and 25 shares constructively (50 percent of the 50 shares 
owned directly by the estate); B is considered as owning 43 shares, 18 
shares directly and 25 shares constructively (50 percent of the 50 
shares owned directly by the estate); C is considered as owning 20 
shares directly and no shares constructively. C is not considered a 
beneficiary of the estate under section 318(a) since he has no direct 
present interest in the property held by the estate nor in the income 
produced by such property.
    (c) If section 318(a)(5)(C) does not apply, A is considered as 
owning nine additional

[[Page 69]]

shares (50 percent of the 18 shares owned constructively by the estate 
through B), and B is considered as owning six additional shares (50 
percent of the 12 shares owned constructively by the estate through A).
    Example 2. Under the will of A, Blackacre is left to B for life, 
remainder to C, an unrelated individual. The residue of the estate 
consisting of stock of a corporation is left to D. B and D are 
beneficiaries of the estate under section 318(a). C is not considered a 
beneficiary since he has no direct present interest in Blackacre nor in 
the income produced by such property. The stock owned by the estate is 
considered as owned proportionately by B and D.

    (b) For the purpose of section 318(a)(2)(B) stock owned by a trust 
will be considered as being owned by its beneficiaries only to the 
extent of the interest of such beneficiaries in the trust. Accordingly, 
the interest of income beneficiaries, remainder beneficiaries, and other 
beneficiaries will be computed on an actuarial basis. Thus, if a trust 
owns 100 percent of the stock of Corporation A, and if, on an actuarial 
basis, W's life interest in the trust is 15 percent, Y's life interest 
is 25 percent, and Z's remainder interest is 60 percent, under this 
provision W will be considered to be the owner of 15 percent of the 
stock of Corporation A, Y will be considered to be the owner of 25 
percent of such stock, and Z will be considered to be the owner of 60 
percent of such stock. The factors and methods prescribed in Sec. 
20.2031-7 of this chapter (Estate Tax Regulations) for use in 
ascertaining the value of an interest in property for estate tax 
purposes shall be used in determining a beneficiary's actuarial interest 
in a trust for purposes of this section. See Sec. 20.2031-7 of this 
chapter (Estate Tax Regulations) for examples illustrating the use of 
these factors and methods.
    (c) The application of section 318(a) relating to options may be 
illustrated by the following example:

    Example. A and B, unrelated individuals, own all of the 100 
outstanding shares of stock of a corporation, each owning 50 shares. A 
has an option to acquire 25 of B's shares and has an option to acquire a 
further option to acquire the remaining 25 of B's shares. A is 
considered as owning the entire 100 shares of stock of the corporation.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6969, 33 FR 
11999, Aug. 23, 1968]



Sec. 1.318-4  Constructive ownership as actual ownership; exceptions.

    (a) In general. Section 318(a)(5)(A) provides that, except as 
provided in section 318(a)(5) (B) and (C), stock constructively owned by 
a person by reason of the application of section 318(a) (1), (2), (3), 
or (4) shall be considered as actually owned by such person for purposes 
of applying section 318(a) (1), (2), (3), and (4). For example, if a 
trust owns 50 percent of the stock of corporation X, stock of 
corporation Y owned by corporation X which is attributed to the trust 
may be further attributed to the beneficiaries of the trust.
    (b) Constructive family ownership. Section 318(a)(5)(B) provides 
that stock constructively owned by an individual by reason of ownership 
by a member of his family shall not be considered as owned by him for 
purposes of making another family member the constructive owner of such 
stock under section 318(a)(1). For example, if F and his two sons, A and 
B, each own one-third of the stock of a corporation, under section 
318(a)(1), A is treated as owning constructively the stock owned by his 
father but is not treated as owning the stock owned by B. Section 
318(a)(5)(B) prevents the attribution of the stock of one brother 
through the father to the other brother, an attribution beyond the scope 
of section 318(a)(1) directly.
    (c) Reattribution. (1) Section 318(a)(5)(C) provides that stock 
constructively owned by a partnership, estate, trust, or corporation by 
reason of the application of section 318(a)(3) shall not be considered 
as owned by it for purposes of applying section 318(a)(2) in order to 
make another the constructive owner of such stock. For example, if two 
unrelated individuals are beneficiaries of the same trust, stock held by 
one which is attributed to the trust under section 318(a)(3) is not 
reattributed from the trust to the other beneficiary. However, stock 
constructively owned by reason of section 318(a)(2) may be reattributed 
under section 318(a)(3). Thus, for example, if all the stock of 
corporations X and Y is owned by A, stock of corporation Z held by X is 
attributed to Y through A.
    (2) Section 318(a)(5)(C) does not prevent reattribution under 
section 318(a)(2) of stock constructively owned

[[Page 70]]

by an entity under section 318(a)(3) if the stock is also constructively 
owned by the entity under section 318(a)(4). For example, if individuals 
A and B are beneficiaries of a trust and the trust has an option to buy 
stock from A, B is considered under section 318(a)(2)(B) as owning a 
proportionate part of such stock.
    (3) Section 318(a)(5)(C) is effective on and after August 31, 1964, 
except that for purposes of sections 302 and 304 it does not apply with 
respect to distributions in payment for stock acquisitions or 
redemptions if such acquisitions or redemptions occurred before August 
31, 1964.

[T.D. 6969, 33 FR 11999, Aug. 23, 1968]

                         Corporate Liquidations

                          effects on recipients



Sec. 1.331-1  Corporate liquidations.

    (a) In general. Section 331 contains rules governing the extent to 
which gain or loss is recognized to a shareholder receiving a 
distribution in complete or partial liquidation of a corporation. Under 
section 331(a)(1), it is provided that amounts distributed in complete 
liquidation of a corporation shall be treated as in full payment in 
exchange for the stock. Under section 331(a)(2), it is provided that 
amounts distributed in partial liquidation of a corporation shall be 
treated as in full or part payment in exchange for the stock. For this 
purpose, the term partial liquidation shall have the meaning ascribed in 
section 346. If section 331 is applicable to the distribution of 
property by a corporation, section 301 (relating to the effects on a 
shareholder of distributions of property) has no application other than 
to a distribution in complete liquidation to which section 316(b)(2)(B) 
applies. See paragraph (b)(2) of Sec. 1.316-1.
    (b) Gain or loss. The gain or loss to a shareholder from a 
distribution in partial or complete liquidation is to be determined 
under section 1001 by comparing the amount of the distribution with the 
cost or other basis of the stock. The gain or loss will be recognized to 
the extent provided in section 1002 and will be subject to the 
provisions of parts I, II, and III (section 1201 and following), 
subchapter P, chapter 1 of the Code.
    (c) Recharacterization. A liquidation which is followed by a 
transfer to another corporation of all or part of the assets of the 
liquidating corporation or which is preceded by such a transfer may, 
however, have the effect of the distribution of a dividend or of a 
transaction in which no loss is recognized and gain is recognized only 
to the extent of ``other property.'' See sections 301 and 356.
    (d) Reporting requirement--(1) General rule. Every significant 
holder that transfers stock to the issuing corporation in exchange for 
property from such corporation must include on or with such holder's 
return for the year of such exchange the statement described in 
paragraph (d)(2) of this section unless--
    (i) The property is part of a distribution made pursuant to a 
corporate resolution reciting that the distribution is made in complete 
liquidation of the corporation; and
    (ii) The issuing corporation is completely liquidated and dissolved 
within one year after the distribution.
    (2) Statement. If required by paragraph (d)(1) of this section, a 
significant holder must include on or with such holder's return a 
statement entitled, ``STATEMENT PURSUANT TO Sec. 1.331-1(d) BY [INSERT 
NAME AND TAXPAYER IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A 
SIGNIFICANT HOLDER OF THE STOCK OF [INSERT NAME AND EMPLOYER 
IDENTIFICATION NUMBER (IF ANY) OF ISSUING CORPORATION].'' If a 
significant holder is a controlled foreign corporation (within the 
meaning of section 957), each United States shareholder (within the 
meaning of section 951(b)) with respect thereto must include this 
statement on or with its return. The statement must include--
    (i) The fair market value and basis of the stock transferred by the 
significant holder to the issuing corporation; and
    (ii) A description of the property received by the significant 
holder from the issuing corporation.
    (3) Definitions. For purposes of this section:

[[Page 71]]

    (i) Significant holder means any person that, immediately before the 
exchange--
    (A) Owned at least five percent (by vote or value) of the total 
outstanding stock of the issuing corporation if the stock owned by such 
person is publicly traded; or
    (B) Owned at least one percent (by vote or value) of the total 
outstanding stock of the issuing corporation if the stock owned by such 
person is not publicly traded.
    (ii) Publicly traded stock means stock that is listed on--
    (A) A national securities exchange registered under section 6 of the 
Securities Exchange Act of 1934 (15 U.S.C. 78f); or
    (B) An interdealer quotation system sponsored by a national 
securities association registered under section 15A of the Securities 
Exchange Act of 1934 (15 U.S.C. 78o-3).
    (iii) Issuing corporation means the corporation that issued the 
shares of stock, some or all of which were transferred by a significant 
holder to such corporation in the exchange described in paragraph (d)(1) 
of this section.
    (4) Cross reference. See section 6043 of the Code for requirements 
relating to a return by a liquidating corporation.
    (e) Example. The provisions of this section may be illustrated by 
the following example:

    Example. A, an individual who makes his income tax returns on the 
calendar year basis, owns 20 shares of stock of the P Corporation, a 
domestic corporation, 10 shares of which were acquired in 1951 at a cost 
of $1,500 and the remainder of 10 shares in December 1954 at a cost of 
$2,900. He receives in April 1955 a distribution of $250 per share in 
complete liquidation, or $2,500 on the 10 shares acquired in 1951, and 
$2,500 on the 10 shares acquired in December 1954. The gain of $1,000 on 
the shares acquired in 1951 is a long-term capital gain to be treated as 
provided in parts I, II, and III (section 1201 and following), 
subchapter P, chapter 1 of the Code. The loss of $400 on the shares 
acquired in 1954 is a short-term capital loss to be treated as provided 
in parts I, II, and III (section 1201 and following), subchapter P, 
chapter 1 of the Code.
    (f) Effective/applicability date. Paragraph (d) of this section 
applies to any taxable year beginning on or after May 30, 2006. However, 
taxpayers may apply paragraph (d) of this section to any original 
Federal income tax return (including any amended return filed on or 
before the due date (including extensions) of such original return) 
timely filed on or after May 30, 2006. For taxable years beginning 
before May 30, 2006, see Sec. 1.331-1 as contained in 26 CFR part 1 in 
effect on April 1, 2006.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6949, 33 FR 
5521, Apr. 9, 1968; T.D. 9264, 71 FR 30594, May 30, 2006; T.D. 9329, 72 
FR 32797, June 14, 2007]



Sec. 1.332-1  Distributions in liquidation of subsidiary corporation; general.

    Under the general rule prescribed by section 331 for the treatment 
of distributions in liquidation of a corporation, amounts received by 
one corporation in complete liquidation of another corporation are 
treated as in full payment in exchange for stock in such other 
corporation, and gain or loss from the receipt of such amounts is to be 
determined as provided in section 1001. Section 332 excepts from the 
general rule property received, under certain specifically described 
circumstances, by one corporation as a distribution in complete 
liquidation of the stock of another corporation and provides for the 
nonrecognition of gain or loss in those cases which meet the statutory 
requirements. Section 367 places a limitation on the application of 
section 332 in the case of foreign corporations. See section 334(b) for 
the basis for determining gain or loss from the subsequent sale of 
property received upon complete liquidations such as described in this 
section. See section 453(d)(4)(A) relative to distribution of 
installment obligations by subsidiary.



Sec. 1.332-2  Requirements for nonrecognition of gain or loss.

    (a) The nonrecognition of gain or loss is limited to the receipt of 
such property by a corporation which is the actual owner of stock (in 
the liquidating corporation) possessing at least 80 percent of the total 
combined voting power of all classes of stock entitled to vote and the 
owner of at least 80 percent of the total number of shares of all other 
classes of stock (except nonvoting stock which is limited and preferred 
as to dividends). The recipient corporation must have been the owner

[[Page 72]]

of the specified amount of such stock on the date of the adoption of the 
plan of liquidation and have continued so to be at all times until the 
receipt of the property. If the recipient corporation does not continue 
qualified with respect to the ownership of stock of the liquidating 
corporation and if the failure to continue qualified occurs at any time 
prior to the completion of the transfer of all the property, the 
provisions for the nonrecognition of gain or loss do not apply to any 
distribution received under the plan.
    (b) Section 332 applies only to those cases in which the recipient 
corporation receives at least partial payment for the stock which it 
owns in the liquidating corporation. If section 332 is not applicable, 
see section 165(g) relative to allowance of losses on worthless 
securities.
    (c) To constitute a distribution in complete liquidation within the 
meaning of section 332, the distribution must be (1) made by the 
liquidating corporation in complete cancellation or redemption of all of 
its stock in accordance with a plan of liquidation, or (2) one of a 
series of distributions in complete cancellation or redemption of all 
its stock in accordance with a plan of liquidation. Where there is more 
than one distribution, it is essential that a status of liquidation 
exist at the time the first distribution is made under the plan and that 
such status continue until the liquidation is completed. Liquidation is 
completed when the liquidating corporation and the receiver or trustees 
in liquidation are finally divested of all the property (both tangible 
and intangible). A status of liquidation exists when the corporation 
ceases to be a going concern and its activities are merely for the 
purpose of winding up its affairs, paying its debts, and distributing 
any remaining balance to its shareholders. A liquidation may be 
completed prior to the actual dissolution of the liquidating 
corporation. However, legal dissolution of the corporation is not 
required. Nor will the mere retention of a nominal amount of assets for 
the sole purpose of preserving the corporation's legal existence 
disqualify the transaction. (See 26 CFR (1939) 39.22(a)-20 (Regulations 
118).)
    (d) If a transaction constitutes a distribution in complete 
liquidation within the meaning of the Internal Revenue Code of 1954 and 
satisfies the requirements of section 332, it is not material that it is 
otherwise described under the local law. If a liquidating corporation 
distributes all of its property in complete liquidation and if pursuant 
to the plan for such complete liquidation a corporation owning the 
specified amount of stock in the liquidating corporation receives 
property constituting amounts distributed in complete liquidation within 
the meaning of the Code and also receives other property attributable to 
shares not owned by it, the transfer of the property to the recipient 
corporation shall not be treated, by reason of the receipt of such other 
property, as not being a distribution (or one of a series of 
distributions) in complete cancellation or redemption of all of the 
stock of the liquidating corporation within the meaning of section 332, 
even though for purposes of those provisions relating to corporate 
reorganizations the amount received by the recipient corporation in 
excess of its ratable share is regarded as acquired upon the issuance of 
its stock or securities in a tax-free exchange as described in section 
361 and the cancellation or redemption of the stock not owned by the 
recipient corporation is treated as occurring as a result of a taxfree 
exchange described in section 354.
    (e) The application of these rules may be illustrated by the 
following example:

    Example. On September 1, 1954, the M Corporation had outstanding 
capital stock consisting of 3,000 shares of common stock, par value $100 
a share, and 1,000 shares of preferred stock, par value $100 a share, 
which preferred stock was limited and preferred as to dividends and had 
no voting rights. On that date, and thereafter until the date of 
dissolution of the M Corporation, the O Corporation owned 2,500 shares 
of common stock of the M Corporation. By statutory merger consummated on 
October 1, 1954, pursuant to a plan of liquidation adopted on September 
1, 1954, the M Corporation was merged into the O Corporation, the O 
Corporation under the plan issuing stock which was received by the other 
holders of the stock of the M Corporation. The receipt by the O 
Corporation of the

[[Page 73]]

properties of the M Corporation is a distribution received by the O 
Corporation in complete liquidation of the M Corporation within the 
meaning of section 332, and no gain or loss is recognized as the result 
of the receipt of such properties.



Sec. 1.332-3  Liquidations completed within one taxable year.

    If in a liquidation completed within one taxable year pursuant to a 
plan of complete liquidation, distributions in complete liquidation are 
received by a corporation which owns the specified amount of stock in 
the liquidating corporation and which continues qualified with respect 
to the ownership of such stock until the transfer of all the property 
within such year is completed (see paragraph (a) of Sec. 1.332-2), then 
no gain or loss shall be recognized with respect to the distributions 
received by the recipient corporation. In such case no waiver or bond is 
required of the recipient corporation under section 332.



Sec. 1.332-4  Liquidations covering more than one taxable year.

    (a) If the plan of liquidation is consummated by a series of 
distributions extending over a period of more than one taxable year, the 
nonrecognition of gain or loss with respect to the distributions in 
liquidation shall, in addition to the requirements of Sec. 1.332-2, be 
subject to the following requirements:
    (1) In order for the distribution in liquidation to be brought 
within the exception provided in section 332 to the general rule for 
computing gain or loss with respect to amounts received in liquidation 
of a corporation, the entire property of the corporation shall be 
transferred in accordance with a plan of liquidation, which plan shall 
include a statement showing the period within which the transfer of the 
property of the liquidating corporation to the recipient corporation is 
to be completed. The transfer of all the property under the liquidation 
must be completed within three years from the close of the taxable year 
during which is made the first of the series of distributions under the 
plan.
    (2) For each of the taxable years which falls wholly or partly 
within the period of liquidation, the recipient corporation shall, at 
the time of filing its return, file with the district director of 
internal revenue a waiver of the statute of limitations on assessment. 
The waiver shall be executed on such form as may be prescribed by the 
Commissioner and shall extend the period of assessment of all income and 
profits taxes for each such year to a date not earlier than one year 
after the last date of the period for assessment of such taxes for the 
last taxable year in which the transfer of the property of such 
liquidating corporation to the controlling corporation may be completed 
in accordance with section 332. Such waiver shall also contain such 
other terms with respect to assessment as may be considered by the 
Commissioner to be necessary to insure the assessment and collection of 
the correct tax liability for each year within the period of 
liquidation.
    (3) For each of the taxable years which falls wholly or partly 
within the period of liquidation, the recipient corporation may be 
required to file a bond, the amount of which shall be fixed by the 
district director. The bond shall contain all terms specified by the 
Commissioner, including provisions unequivocally assuring prompt payment 
of the excess of income and profits taxes (plus penalty, if any, and 
interest) as computed by the district director without regard to the 
provisions of sections 332 and 334(b) over such taxes computed with 
regard to such provisions, regardless of whether such excess may or may 
not be made the subject of a notice of deficiency under section 6212 and 
regardless of whether it may or may not be assessed. Any bond required 
under section 332 shall have such surety or sureties as the Commissioner 
may require. However, see 6 U.S.C. 15, providing that where a bond is 
required by law or regulations, in lieu of surety or sureties there may 
be deposited bonds or notes of the United States. Only surety companies 
holding certificates of authority from the Secretary as acceptable 
sureties on Federal bonds will be approved as sureties. The bonds shall 
be executed in triplicate so that the Commissioner, the taxpayer, and 
the surety or the depositary may each have a copy. On and after 
September 1, 1953, the functions of the Commissioner with respect to 
such bonds shall be performed by the

[[Page 74]]

district director for the internal revenue district in which the return 
was filed and any bond filed on or after such date shall be filed with 
such district director.
    (b) Pending the completion of the liquidation, if there is a 
compliance with paragraph (a) (1), (2), and (3) of this section and 
Sec. 1.332-2 with respect to the nonrecognition of gain or loss, the 
income and profits tax liability of the recipient corporation for each 
of the years covered in whole or in part by the liquidation shall be 
determined without the recognition of any gain or loss on account of the 
receipt of the distributions in liquidation. In such determination, the 
basis of the property or properties received by the recipient 
corporation shall be determined in accordance with section 334(b). 
However, if the transfer of the property is not completed within the 
three-year period allowed by section 332 or if the recipient corporation 
does not continue qualified with respect to the ownership of stock of 
the liquidating corporation as required by that section, gain or loss 
shall be recognized with respect to each distribution and the tax 
liability for each of the years covered in whole or in part by the 
liquidation shall be recomputed without regard to the provisions of 
section 332 or section 334(b) and the amount of any additional tax due 
upon such recomputation shall be promptly paid.



Sec. 1.332-5  Distributions in liquidation as affecting minority interests.

    Upon the liquidation of a corporation in pursuance of a plan of 
complete liquidation, the gain or loss of minority shareholders shall be 
determined without regard to section 332, since it does not apply to 
that part of distributions in liquidation received by minority 
shareholders.



Sec. 1.332-6  Records to be kept and information to be filed with return.

    (a) Statement filed by recipient corporation. If any recipient 
corporation received a liquidating distribution from the liquidating 
corporation pursuant to a plan (whether or not that recipient 
corporation has received or will receive other such distributions from 
the liquidating corporation in other tax years as part of the same plan) 
during the current tax year, such recipient corporation must include a 
statement entitled, ``STATEMENT PURSUANT TO SECTION 332 BY [INSERT NAME 
AND EMPLOYER IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A CORPORATION 
RECEIVING A LIQUIDATING DISTRIBUTION,'' on or with its return for such 
year. If any recipient corporation is a controlled foreign corporation 
(within the meaning of section 957), each United States shareholder 
(within the meaning of section 951(b)) with respect thereto must include 
this statement on or with its return. The statement must include--
    (1) The name and employer identification number (if any) of the 
liquidating corporation;
    (2) The date(s) of all distribution(s) (whether or not pursuant to 
the plan) by the liquidating corporation during the current tax year;
    (3) The aggregate fair market value and basis, determined 
immediately before the liquidation, of all of the assets of the 
liquidating corporation that have been or will be transferred to any 
recipient corporation;
    (4) The date and control number of any private letter ruling(s) 
issued by the Internal Revenue Service in connection with the 
liquidation;
    (5) The following representation: THE PLAN OF COMPLETE LIQUIDATION 
WAS ADOPTED ON [INSERT DATE (mm/dd/yyyy)]; and
    (6) A representation by such recipient corporation either that--
    (i) THE LIQUIDATION WAS COMPLETED ON [INSERT DATE (mm/dd/yyyy)]; or
    (ii) THE LIQUIDATION IS NOT COMPLETE AND THE TAXPAYER HAS TIMELY 
FILED [INSERT EITHER FORM 952, ``Consent To Extend the Time to Assess 
Tax Under Section 332(b),'' OR NUMBER AND NAME OF THE SUCCESSOR FORM].
    (b) Filings by the liquidating corporation. The liquidating 
corporation must timely file Form 966, ``Corporate Dissolution or 
Liquidation,'' (or its successor form) and its final Federal corporate 
income tax return. See also section 6043 of the Code.
    (c) Definitions. For purposes of this section:

[[Page 75]]

    (1) Plan means the plan of complete liquidation within the meaning 
of section 332.
    (2) Recipient corporation means the corporation described in section 
332(b)(1).
    (3) Liquidating corporation means the corporation that makes a 
distribution of property to a recipient corporation pursuant to the 
plan.
    (4) Liquidating distribution means a distribution of property made 
by the liquidating corporation to a recipient corporation pursuant to 
the plan.
    (d) Substantiation information. Under Sec. 1.6001-1(e), taxpayers 
are required to retain their permanent records and make such records 
available to any authorized Internal Revenue Service officers and 
employees. In connection with a liquidation described in this section, 
these records should specifically include information regarding the 
amount, basis, and fair market value of all distributed property, and 
relevant facts regarding any liabilities assumed or extinguished as part 
of such liquidation.
    (e) Effective/applicability date. This section applies to any 
taxable year beginning on or after May 30, 2006. However, taxpayers may 
apply this section to any original Federal income tax return (including 
any amended return filed on or before the due date (including 
extensions) of such original return) timely filed on or after May 30, 
2006. For taxable years beginning before May 30, 2006, see Sec. 1.332-6 
as contained in 26 CFR part 1 in effect on April 1, 2006.

[T.D. 9329, 72 FR 32797, June 14, 2007]



Sec. 1.332-7  Indebtedness of subsidiary to parent.

    If section 332(a) is applicable to the receipt of the subsidiary's 
property in complete liquidation, then no gain or loss shall be 
recognized to the subsidiary upon the transfer of such properties even 
though some of the properties are transferred in satisfaction of the 
subsidiary's indebtedness to its parent. However, any gain or loss 
realized by the parent corporation on such satisfaction of indebtedness, 
shall be recognized to the parent corporation at the time of the 
liquidation. For example, if the parent corporation purchased its 
subsidiary's bonds at a discount and upon liquidation of the subsidiary 
the parent corporation receives payment for the face amount of such 
bonds, gain shall be recognized to the parent corporation. Such gain 
shall be measured by the difference between the cost or other basis of 
the bonds to the parent and the amount received in payment of the bonds.



Sec. 1.334-1  Basis of property received in liquidations.

    (a) In general. Section 334 sets forth rules prescribing the basis 
of property received in a distribution in partial or complete 
liquidation of a corporation. The general rule of section 334 is set 
forth in section 334(a) to the effect that if property is received in a 
distribution in partial or complete liquidation and if gain or loss is 
recognized on the receipt of such property, then the basis of the 
property in the hands of the distributee shall be the fair market value 
of such property at the time of the distribution. Such general rule has 
no application to a liquidation to which section 332 or section 333 
applies. See section 334 (b) and (c).
    (b) Transferor's basis. Unless section 334(b)(2) and subsection (c) 
of this section apply, property received by a parent corporation in a 
complete liquidation to which section 332 is applicable shall, under 
section 334(b)(1), have the same basis in the hands of the parent as its 
adjusted basis in the hands of the subsidiary. The rule stated above is 
applicable even though the subsidiary was indebted to the parent on the 
date the plan of liquidation was adopted and part of such property was 
received in satisfaction of such indebtedness in a transfer to which 
section 332(c) is applicable. See Sec. 1.460-4(k)(3)(iv)(B)(2) for 
rules relating to adjustments to the basis of certain contracts 
accounted for using a long-term contract method of accounting that are 
acquired in certain liquidations described in section 332.

[T.D. 7231, 37 FR 28287, Dec. 22, 1972, as amended at T.D. 8474, 58 FR 
25557, Apr. 27, 1993; T.D. 8995, 67 FR 34605, May 15, 2002]

[[Page 76]]

                         effects on corporation



Sec. 1.337(d)-1  Transitional loss limitation rule.

    (a) Loss limitation rule for transitional subsidiary--(1) General 
rule. No deduction is allowed for any loss recognized by a member of a 
consolidated group with respect to the disposition of stock of a 
transitional subsidiary. However, for transactions involving loss shares 
of subsidiary stock occurring on or after September 17, 2008, see Sec. 
1.1502-36. Further, this section does not apply to a transaction that is 
subject to Sec. 1.1502-36.
    (2) Allowable loss--(i) In general. Paragraph (a)(1) of this section 
does not apply to the extent the taxpayer establishes that the loss is 
not attributable to the recognition of built-in gain by any transitional 
subsidiary on the disposition of an asset (including stock and 
securities) after January 6, 1987.
    (ii) Statement of allowable loss. Paragraph (a)(2)(i) of this 
section applies only if a separate statement entitled ``Allowable Loss 
Under Sec. 1.337(d)-1(a)'' is filed with the taxpayer's return for the 
year of the stock disposition. If the separate statement is required to 
be filed with a return the due date (including extensions) of which is 
before January 16, 1991, or with a return due (including extensions) 
after January 15, 1991 but filed before that date, the statement may be 
filed with an amended return for the year of the disposition or with the 
taxpayer's first subsequent return the due date (including extensions) 
of which is after January 15, 1991.
    (iii) Contents of statement. The statement required under paragraph 
(a)(2)(ii) of this section must contain--
    (A) The name and employer identification number (E.I.N.) of the 
transitional subsidiary.
    (B) The basis of the stock of the transitional subsidiary 
immediately before the disposition.
    (C) The amount realized on the disposition.
    (D) The amount of the deduction not disallowed under paragraph 
(a)(1) of this section by reason of this paragraph (a)(2).
    (E) The amount of loss disallowed under paragraph (a)(1) of this 
section.
    (3) Coordination with loss deferral and other disallowance rules. 
(i) For purposes of this section, the rules of Sec. 1.1502-20(a)(3) 
apply, with appropriate adjustments to reflect differences between the 
approach of this section and that of Sec. 1.1502-20.
    (ii) Other loss deferral rules. If paragraph (a)(1) of this section 
applies to a loss subject to deferral or disallowance under any other 
provision of the Code or the regulations, the other provision applies to 
the loss only to the extent it is not disallowed under paragraph (a)(1).
    (4) Definitions. For purposes of this section--
    (i) The definitions in Sec. 1.1502-1 apply.
    (ii) Transitional subsidiary means any corporation that became a 
subsidiary of the group (whether or not the group was a consolidated 
group) after January 6, 1987. Notwithstanding the preceding sentence, a 
subsidiary is not a transitional subsidiary if the subsidiary (and each 
predecessor) was a member of the group at all times after the 
subsidiary's (and each predecessor's) organization.
    (iii) Built-in gain of a transitional subsidiary means gain 
attributable, directly or indirectly, in whole or in part, to any excess 
of value over basis, determined immediately before the transitional 
subsidiary became a subsidiary, with respect to any asset owned directly 
or indirectly by the transitional subsidiary at that time.
    (iv) Disposition means any event in which gain or loss is 
recognized, in whole or in part.
    (v) Value means fair market value.
    (5) Examples. For purposes of the examples in this section, unless 
otherwise stated, the group files consolidated returns on a calendar 
year basis, the facts set forth the only corporate activity, and all 
sales and purchases are with unrelated buyers or sellers. The basis of 
each asset is the same determining earnings and profits adjustments and 
taxable income. Tax liability and its effect on basis, value, and 
earnings and profits are disregarded. Investment adjustment system means 
the rules of Sec. 1.1502-32. The principles of this paragraph (a) are 
illustrated by the following examples:


[[Page 77]]


    Example 1. Loss attributable to recognized built-in gain. (i) P buys 
all the stock of T for $100 on February 1, 1987, and T becomes a member 
of the P group. T has an asset with a value of $100 and basis of $0. T 
sells the asset in 1989 and recognizes $100 of built-in gain on the sale 
(i.e., the asset's value exceeded its basis by $100 at the time T became 
a member of the P group). Under the investment adjustment system, P's 
basis in the T stock increases to $200. P sells all the stock of T on 
December 31, 1989, and recognizes a loss of $100. Under paragraph (a)(1) 
of this section, no deduction is allowed to P for the $100 loss.
    (ii) Assume that, after T sells its asset but before P sells the T 
stock, T issues additional stock to unrelated persons and ceases to be a 
member of the P group. P then sells all its stock of T in 1997. Although 
T ceases to be a subsidiary within the meaning of Sec. 1.1502-1, T 
continues to be a transitional subsidiary within the meaning of this 
section. Consequently, under paragraph (a)(1) of this section, no 
deduction is allowed to P for its $100 loss.
    Example 2. Loss attributable to post-acquisition loss.
    P buys all the stock of T for $100 on February 1, 1987, and T 
becomes a member of the P group. T has $50 cash and an asset with $50 of 
built-in gain. During 1988, T retains the asset but loses $40 of the 
cash. The P group is unable to use the loss, and the loss becomes a net 
operating loss carryover attributable to T. Under the investment 
adjustment system, P's basis in the stock of T remains $100. P sells all 
the stock of T on December 31, 1988, for $60 and recognizes a $40 loss. 
Under paragraph (a)(2)(i) of this section, P establishes that it did not 
dispose of the built-in gain asset. None of P's loss is disallowed under 
paragraph (a)(1) if P satisfies the requirements of paragraph (a)(2)(ii) 
of this section.
    Example 3. Stacking rules--postacquisition loss offsets 
postacquisition gain. (i) P buys all the stock of T for $100 on February 
1, 1987, and T becomes a member of the P group. T has 2 assets. Asset 1 
has a basis and value of $50, and asset 2 has a basis of $0 and a value 
of $50. During 1989, asset 1 declines in value to $0, and T sells asset 
2 for $50, and reinvests the proceeds in asset 3. The value of asset 3 
appreciates to $90. Under the investment adjustment system, P's basis in 
the stock of T increases from $100 to $150 as a result of the gain 
recognized on the sale of asset 2 but is unaffected by the unrealized 
post-acquisition decline in the value of asset 1. On December 31, 1989, 
P sells all the stock of T for $90 and recognizes a $60 loss.
    (ii) Although T incurred a $50 post-acquisition loss of built-in 
gain because of the decline in the value of asset 1, T also recognized 
$50 of built-in gain. Under paragraph (a)(2) of this section, any loss 
on the sale of stock is treated first as attributable to recognized 
built-in gain. Thus, for purposes of determining under paragraph (a)(2) 
of this section whether P's $60 loss on the disposition of the T stock 
is attributable to the recognition of built-in gain on the disposition 
of an asset, T's unrealized post-acquisition gain of $40 offsets $40 of 
the $50 of unrealized post-acquisition loss. Therefore, $50 of the $60 
loss is attributable to the recognition of built-in gain on the 
disposition of an asset and is disallowed under paragraph (a)(1) of this 
section.
    Example 4. Stacking rules--built-in loss offsets built-in gain. (i) 
P buys all the stock of T for $50 on February 1, 1987, and T becomes a 
member of the P group. T has 2 assets. Asset 1 has a basis of $50 and a 
value of $0, and asset 2 has a basis of $0 and a value of $50. During 
1989, T sells asset 1 for $0 and asset 2 for $50, and reinvests the $50 
proceeds in asset 3. The value of asset 3 declines to $40. Under the 
investment adjustment system, P's basis in the stock of T remains $50 as 
a result of the offsetting gain and loss recognized on the sale of 
assets 1 and 2 and is unaffected by the unrealized post-acquisition 
decline in the value of asset 3. On December 31, 1989, P sells all the 
stock of T for $40 and recognizes a $10 loss.
    (ii) Although T recognized a $50 built-in gain on the sale of asset 
2, T also recognized a $50 built-in loss on the sale of asset 1. For 
purposes of determining under paragraph (a)(2) of this section whether 
P's $10 loss on the disposition of the T stock is attributable to the 
recognition of built-in gain on the disposition of an asset, T's 
recognized built-in gain is offset by its recognized built-in loss. Thus 
none of P's $10 loss is attributable to the recognition of built-in gain 
on the disposition of an asset.
    (iii) The result would be the same if, instead of a $50 built-in 
loss in asset 2, T has a $50 net operating loss carryover when P buys 
the T stock, and the net operating loss carryover is used to offset the 
built-in gain.
    Example 5. Outside basis partially corresponds to inside basis. (i) 
Individual A owns all the stock of T, for which A has a basis of $60. On 
February 1, 1987, T owns 1 asset with a basis of $0 and a value of $100, 
P acquires all the stock of T from A in an exchange to which section 
351(a) applies, and T becomes a member of the P group. P has a carryover 
basis of $60 in the T stock. During 1988, T sells the asset and 
recognizes $100 of gain. Under the investment adjustment system, P's 
basis in the T stock increases from $60 to $160. T reinvests the $100 
proceeds in another asset, which declines in value to $90. On January 1, 
1989, P sells all the stock of T for $90 and recognizes a loss of $70.
    (ii) Although P's basis in the T stock was increased by $100 as a 
result of the recognition of built-in gain on the disposition of T's 
asset, only $60 of the $70 loss on the sale of

[[Page 78]]

the stock is attributable under paragraph (a)(2) of this section to the 
recognition of built-in gain from the disposition of the asset. (Had T's 
asset not declined in value to $90, the T stock would have been sold for 
$100, and a $60 loss would have been attributable to the recognition of 
the built-in gain.) Therefore, $60 of the $70 loss is disallowed under 
paragraph (a)(2), and $10 is not disallowed if P satisfies the 
requirements of paragraph (a)(2). If P had sold the stock of T for $95 
because T's other assets had unrealized appreciation of $5, $60 of the 
$65 loss would still be attributable to T's recognition of built-in gain 
on the disposition of assets.
    Example 6. Creeping acquisition. P owns 60 percent of the stock of S 
on January 6, 1987. On February 1, 1987, P buys an additional 20 percent 
of the stock of S, and S becomes a member of the P group. P sells all 
the S stock on March 1, 1989 and recognizes a loss of $100. All 80 
percent of the stock of S owned by P is subject to the rules of this 
section and, under paragraph (a) (1) and (2) of this section, P is not 
allowed to deduct the $100 loss, except to the extent P establishes the 
loss is not attributable to the recognition by S of built-in gain on the 
disposition of assets.
    Example 7. Effect of post-acquisition appreciation. P buys all the 
stock of T for $100, and T becomes a member of the P group. T has an 
asset with a basis of $0 and a value of $100. T sells the asset for 
$100. Under the investment adjustment system, P's basis in the T stock 
increases to $200. T reinvests the proceeds of the sale in an asset that 
appreciates in value to $180. Five years after the sale, P sells all the 
stock of T for $180 and recognizes a $20 loss. Under paragraph (a)(1) of 
this section, no deduction is allowed to P for the $20 loss.
    Example 8. Deferred loss and recognized gain. (i) P is the common 
parent of a consolidated group, S is a wholly owned subsidiary of P, and 
T is a wholly owned subsidiary of S. S purchased all of the T stock on 
February 1, 1987 for $100, and T has an asset with a basis of $40 and a 
value of $100. T sells the asset for $100, recognizing $60 of gain. 
Under the investment adjustment system, S's basis in the T stock 
increases from $100 to $160. S sells its T stock to P for $100 in a 
deferred intercompany transaction, recognizing a $60 loss that is 
deferred under section 267(f) and Sec. 1.1502-13. P subsequently sells 
all the stock of T for $100 to X, a member of the same controlled group 
(as defined in section 267(f)) as P but not a member of the P 
consolidated group.
    (ii) Under paragraph (a)(3) of this section, the application of 
paragraph (a)(1) of this section to S's $60 loss is deferred, because 
S's loss is deferred under section 267(f) and Sec. 1.1502-13. Although 
P's sale of the T stock to X would cause S's deferred loss to be taken 
into account under Sec. 1.1502-13, Sec. 1.267(f)-1 provides that the 
loss is not taken into account because X is a member of the same 
controlled group as P and S. Nevertheless, under paragraph (a)(3) of 
this section, because the T stock ceases to be owned by a member of the 
P consolidated group, S's deferred loss is disallowed immediately before 
the sale and is never taken into account under section 267(f).

    (b) Indirect disposition of transitional subsidiary--(1) Loss 
limitation rule for transitional parent. No deduction is allowed for any 
loss recognized by a member of a consolidated group with respect to the 
disposition of stock of a transitional parent.
    (2) Allowable loss--(i) In general. Paragraph (b)(1) of this section 
does not apply to the extent the taxpayer establishes that the loss 
exceeds the amount that would be disallowed under paragraph (a) of this 
section if each highest tier transitional subsidiary's stock in which 
the transitional parent has a direct or indirect interest had been sold 
immediately before the disposition of the transitional parent's stock. 
In applying the preceding sentence, appropriate adjustments shall be 
made to take into account circumstances where less than all the stock of 
a transitional parent owned by members of a consolidated group is 
disposed of in the same transaction, or the stock of a transitional 
subsidiary or a transitional parent is directly owned by more than 1 
member.
    (ii) Statement of allowable loss. Paragraph (b)(2)(i) of this 
section applies only if a separate statement entitled ``Allowable Loss 
Under Section 1.337(d)-1(b)'' is filed with the taxpayer's return for 
the year of the stock disposition. If the separate statement is required 
to be filed with a return the due date (including extensions) of which 
is before January 16, 1991, or with a return due (including extensions) 
after January 15, 1991 but filed before that date, the statement may be 
filed with an amended return for the year of the disposition or with the 
taxpayer's first subsequent return the due date (including extensions) 
of which is after January 15, 1991.
    (iii) Contents of statement. The statement required under paragraph 
(b)(2)(ii) of this section must contain--
    (A) The name and employer identification number (E.I.N.) of the 
transitional parent.

[[Page 79]]

    (B) The basis of the stock of the transitional parent immediately 
before the disposition.
    (C) The amount realized on the disposition.
    (D) The amount of the deduction not disallowed under paragraph 
(b)(1) of this section by reason of this paragraph (b)(2).
    (E) The amount of loss disallowed under paragraph (b)(1) of this 
section.
    (3) Coordination with loss deferral and other disallowance rules. 
(i) For purposes of this section, the rules of Sec. 1.1502-20(a)(3) 
apply, with appropriate adjustments to reflect differences between the 
approach of this section and that of Sec. 1.1502-20.
    (ii) Other loss deferral rules. If paragraph (b)(1) of this section 
applies to a loss subject to deferral or disallowance under any other 
provision of the Code or the regulations, the other provision applies to 
the loss only to the extent it is not disallowed under paragraph (b)(1).
    (4) Definitions. For purposes of this section--
    (i) Transitional parent means any subsidiary, other than a 
transitional subsidiary, that owned at any time after January 6, 1987, a 
direct or indirect interest in the stock of a corporation that is a 
transitional subsidiary.
    (ii) Highest tier transitional subsidiary means the transitional 
subsidiary (or subsidiaries) in which the transitional parent has a 
direct or indirect interest and that is the highest transitional 
subsidiary (or subsidiaries) in a chain of members.
    (5) Examples. The principles of this paragraph (b) are illustrated 
by the following examples:

    Example 1. Ownership of chain of transitional subsidiaries. (i) P 
forms S with $200 on January 1, 1985, and S becomes a member of the P 
group. On February 1, 1987, S buys all the stock of T, and T buys all 
the stock of T1, and both T and T1 become members of the P group. On 
January 1, 1988, P sells all the stock of S and recognizes a $90 loss on 
the sale.
    (ii) Under paragraph (a)(4)(ii) of this section, both T and T1 are 
transitional subsidiaries, because they became members of the P group 
after January 6, 1987. Under paragraph (b)(4)(i) of this section, S is a 
transitional parent, because it owns a direct interest in stock of 
transitional subsidiaries and is not itself a transitional subsidiary.
    (iii) Under paragraph (b) (1) and (2) of this section, because S is 
a transitional parent, no deduction is allowed to P for its $90 loss 
except to the extent the loss exceeds the amount of S's loss that would 
have been disallowed if S had sold all the stock of T, S's highest tier 
transitional subsidiary, immediately before P's sale of all the S stock. 
Assume all the T stock would have been sold for a $90 loss and that all 
the loss would be attributable to the recognition of built-in gain from 
the disposition of assets. Because in that case $90 of loss would be 
disallowed, all of P's loss on the sale of the S stock is disallowed 
under paragraph (b).
    Example 2. Ownership of brother-sister transitional subsidiaries. 
(i) P forms S with $200 on January 1, 1985, and S becomes a member of 
the P group. On February 1, 1987, S buys all the stock of both T and T1, 
and T and T1 become members of the P group. On January 1, 1988, P sells 
all the stock of S and recognizes a $90 loss on the sale.
    (ii) Under paragraph (b) (1) and (2) of this section, no deduction 
is allowed to P for its $90 loss except to the extent P establishes that 
the loss exceeds the amount of S's stock losses that would be disallowed 
if S sold all the stock of T and T1, S's highest tier transitional 
subsidiaries, immediately before P's sale of all the S stock. Assume 
that all the T stock would have been sold for a $50 loss, all the T1 
stock of a $40 loss, and that the entire amount of each loss would be 
attributable to the recognition of built-in gain on the disposition of 
assets. Because $90 of loss would be disallowed with respect to the sale 
of S's T and T1 stock, P's $90 loss on the sale of all the S stock is 
disallowed under paragraph (b).

    (c) Successors--(1) General rule. This section applies, to the 
extent necessary to effectuate the purposes of this section, to--
    (i) Any property owned by a member or former member, the basis of 
which is determined, directly or indirectly, in whole or in part, by 
reference to the basis in a subsidiary's stock, and
    (ii) Any property owned by any other person whose basis in the 
property is determined, directly or indirectly, in whole or in part, by 
reference to a member's (or former member's) basis in a subsidiary's 
stock.
    (2) Examples. The principles of this paragraph (c) are illustrated 
by the following examples:

    Example 1. Merger into grandfathered subsidiary. P, the common 
parent of a group, owns all the stock of T, a transitional subsidiary. 
On January 1, 1989, T merges into S, a wholly owned subsidiary of P that 
is not a

[[Page 80]]

transitional subsidiary. Under paragraph (c)(1) of this section, all the 
stock of S is treated as stock of a transitional subsidiary. As a 
result, no deduction is allowed for any loss recognized by P on the 
disposition of any S stock, except to the extent the P group establishes 
under paragraph (a)(2) that the loss is not attributable to the 
recognition of built-in gain on the disposition of assets of T.
    Example 2. Nonrecognition exchange of transitional stock. (i) P, the 
common parent of a group, owns all the stock of T, a transitional 
subsidiary. On January 1, 1989, P transfers the stock of T to X, a 
corporation that is not a member of the P group, in exchange for 20 
percent of its stock in a transaction to which section 351(a) applies. T 
and X file separate returns.
    (ii) Under paragraph (c)(1) of this section, all the stock of X 
owned by P is treated as stock of a transitional subsidiary because P's 
basis for the X stock is determined by reference to its basis for the T 
stock. As a result, no deduction is allowed to P for any loss recognized 
on the disposition of the X stock, except to the extent permitted under 
paragraph (a) of this section.
    (iii) Under paragraph (c)(1), X is treated as a member subject to 
paragraph (a) of this section with respect to the T stock because X's 
basis for the stock is determined by reference to P's basis for the 
stock. Moreover, all of the T stock owned by X continues to be stock of 
a transitional subsidiary. As a result, no deduction is allowed to X for 
any loss recognized on the disposition of any T stock, except to the 
extent permitted under paragraph (a) of this section.

    (d) Investment adjustments and earnings and profits--(1) In general. 
For purposes of determining investment adjustments under Sec. 1.1502-32 
and earnings and profits under Sec. 1.1502-33(c) with respect to a 
member of a consolidated group that owns stock in a subsidiary, any 
deduction that is disallowed under this section is treated as a loss 
arising and absorbed by the member in the tax year in which the 
disallowance occurs.
    (2) Example. (i) In 1986, P forms S with a contribution of $100, and 
S becomes a member of the P group. On February 1, 1987, S buys all the 
stock of T for $100. T has an asset with a basis of $0 and a value of 
$100. In 1988, T sells the asset for $100. Under the investment 
adjustment system, S's basis in the T stock increases to adjustment 
system, S's basis in the T stock increases to $200, P's basis in the S 
stock increases to $200, and P's earnings and profits and S's earnings 
and profits increase by $100. In 1989, S sells all of the T stock for 
$100, and S's recognized loss of $100 is disallowed under paragraph 
(a)(1) of this section.
    (ii) Under paragraph (d)(1) of this section, S's earnings and 
profits for 1989 are reduced by $100, the amount of the loss disallowed 
under paragraph (a)(1). As a result, P's basis in the S stock is reduced 
from $200 to $100 under the investment adjustment system. P's earnings 
and profits for 1989 are correspondingly reduced by $100.
    (e) Effective dates--(1) General rule. This section applies with 
respect to dispositions after January 6, 1987. For dispositions on or 
after November 19, 1990, however, this section applies only if the stock 
was deconsolidated (as that term is defined in Sec. 1.337(d)-2(b)(2)) 
before November 19, 1990, and only to the extent the disposition is not 
subject to Sec. 1.337(d)-2 or Sec. 1.1502-20.
    (2) Binding contract rule. For purposes of this paragraph (e), if a 
corporation became a subsidiary pursuant to a binding written contract 
entered into before January 6, 1987, and in continuous effect until the 
corporation became a subsidiary, or a disposition was pursuant to a 
binding written contract entered into before March 9, 1990, and in 
continuous effect until the disposition, the date the contract became 
binding shall be treated as the date the corporation became a subsidiary 
or as the date of disposition.
    (3) Application of Sec. 1.1502-20T to certain transactions--(i) In 
general. If a group files the certification described in paragraph 
(e)(3)(ii) of this section, it may apply Sec. 1.1502-20T (as contained 
in the CFR edition revised as of April 1, 1990), to all of its members 
with respect to all dispositions and deconsolidations by the certifying 
group to which Sec. 1.1502-20T otherwise applied by its terms 
occurring--
    (A) On or after March 9, 1990 (but only if not pursuant to a binding 
contract described in Sec. 1.337(d)-1T(e)(2) (as contained in the CFR 
edition revised as of April 1, 1990) that was entered into before March 
9, 1990); and
    (B) Before November 19, 1990 (or thereafter, if pursuant to a 
binding contract described in Sec. 1.1502-20T(g)(3) that was entered 
into on or after

[[Page 81]]

March 9, 1990 and before November 19, 1990).

The certification under this paragraph (e)(3)(i) with respect to the 
application of Sec. 1.1502-20T to any transaction described in this 
paragraph (e)(3)(i) may not be withdrawn and, if the certification is 
filed, Sec. 1.1502-20T must be applied to all such transactions on all 
returns (including amended returns) on which such transactions are 
included.
    (ii) Time and manner of filing certification. The certification 
described in paragraph (e)(3)(i) of this section must be made in a 
separate statement entitled ``[insert name and employer identification 
number of common parent] hereby certifies under Sec. 1.337(d)-1 (e)(3) 
that the group of which it is the common parent is applying Sec. 
1.1502-20T to all transactions to which that section otherwise applied 
by it terms.'' The statement must be signed by the common parent and 
filed with the group's income tax return for the taxable year of the 
first disposition or deconsolidation to which the certification applies. 
If the separate statement required under this paragraph (e)(3) is to be 
filed with a return the due date (including extensions) of which is 
before November 16, 1991, the statement may be filed with an amended 
return for the year of the disposition or deconsolidation that is filed 
within 180 days after September 13, 1991. Any other filings required 
under Sec. 1.1502-20T, such as the statement required under Sec. 
1.1502-20T(f)(5), may be made with the amended return, regardless of 
whether Sec. 1.1502-20T permits such filing by amended return.

[T.D. 8319, 55 FR 49031, Nov. 26, 1990, as amended by T.D. 8364, 56 FR 
47389, Sept. 19, 1991; 57 FR 53550, Nov. 12, 1992; T.D. 8560, 59 FR 
41674, 41675, Aug. 15, 1994; T.D. 8597, 60 FR 36679, July 18, 1995; T.D. 
9424, 73 FR 53947, Sept. 17, 2008]



Sec. 1.337(d)-1T  [Reserved]



Sec. 1.337(d)-2  Loss limitation rules.

    (a) Loss disallowance--(1) General rule. No deduction is allowed for 
any loss recognized by a member of a consolidated group with respect to 
the disposition of stock of a subsidiary. However, for transactions 
involving loss shares of subsidiary stock occurring on or after 
September 17, 2008, see Sec. 1.1502-36. Further, this section does not 
apply to a transaction that is subject to Sec. 1.1502-36.
    (2) Definitions. For purposes of this section:
    (i) The definitions in Sec. 1.1502-1 apply.
    (ii) Disposition means any event in which gain or loss is 
recognized, in whole or in part.
    (3) Coordination with loss deferral and other disallowance rules. 
For purposes of this section, the rules of Sec. 1.1502-20(a)(3) apply, 
with appropriate adjustments to reflect differences between the approach 
of this section and that of Sec. 1.1502-20.
    (4) Netting. Paragraph (a)(1) of this section does not apply to loss 
with respect to the disposition of stock of a subsidiary, to the extent 
that, as a consequence of the same plan or arrangement, gain is taken 
into account by members with respect to stock of the same subsidiary 
having the same material terms. If the gain to which this paragraph 
applies is less than the amount of the loss with respect to the 
disposition of the subsidiary's stock, the gain is applied to offset 
loss with respect to each share disposed of as a consequence of the same 
plan or arrangement in proportion to the amount of the loss deduction 
that would have been disallowed under paragraph (a)(1) of this section 
with respect to such share before the application of this paragraph 
(a)(4). If the same item of gain could be taken into account more than 
once in limiting the application of paragraphs (a)(1) and (b)(1) of this 
section, the item is taken into account only once.
    (b) Basis reduction on deconsolidation--(1) General rule. If the 
basis of a member of a consolidated group in a share of stock of a 
subsidiary exceeds its value immediately before a deconsolidation of the 
share, the basis of the share is reduced at that time to an amount equal 
to its value. If both a disposition and a deconsolidation occur with 
respect to a share in the same transaction, paragraph (a) of this 
section applies and, to the extent necessary to effectuate the purposes 
of this section, this paragraph (b) applies following the application of 
paragraph (a) of this section.

[[Page 82]]

    (2) Deconsolidation. Deconsolidation means any event that causes a 
share of stock of a subsidiary that remains outstanding to be no longer 
owned by a member of any consolidated group of which the subsidiary is 
also a member.
    (3) Value. Value means fair market value.
    (4) Netting. Paragraph (b)(1) of this section does not apply to 
reduce the basis of stock of a subsidiary, to the extent that, as a 
consequence of the same plan or arrangement, gain is taken into account 
by members with respect to stock of the same subsidiary having the same 
material terms. If the gain to which this paragraph applies is less than 
the amount of basis reduction with respect to shares of the subsidiary's 
stock, the gain is applied to offset basis reduction with respect to 
each share deconsolidated as a consequence of the same plan or 
arrangement in proportion to the amount of the reduction that would have 
been required under paragraph (b)(1) of this section with respect to 
such share before the application of this paragraph (b)(4).
    (c) Allowable loss--(1) Application. This paragraph (c) applies with 
respect to stock of a subsidiary only if a separate statement entitled 
Sec. 1.337(d)-2(c) statement is included with the return in accordance 
with paragraph (c)(3) of this section.
    (2) General rule. Loss is not disallowed under paragraph (a)(1) of 
this section and basis is not reduced under paragraph (b)(1) of this 
section to the extent the taxpayer establishes that the loss or basis is 
not attributable to the recognition of built-in gain, net of directly 
related expenses, on the disposition of an asset (including stock and 
securities). Loss or basis may be attributable to the recognition of 
built-in gain on the disposition of an asset by a prior group. For 
purposes of this section, gain recognized on the disposition of an asset 
is built-in gain to the extent attributable, directly or indirectly, in 
whole or in part, to any excess of value over basis that is reflected, 
before the disposition of the asset, in the basis of the share, directly 
or indirectly, in whole or in part, after applying section 1503(e) and 
other applicable provisions of the Internal Revenue Code and 
regulations. Federal income taxes may be directly related to built-in 
gain recognized on the disposition of an asset only to the extent of the 
excess (if any) of the group's income tax liability actually imposed 
under Subtitle A of the Internal Revenue Code for the taxable year of 
the disposition of the asset over the group's income tax liability for 
the taxable year redetermined by not taking into account the built-in 
gain recognized on the disposition of the asset. For this purpose, the 
group's income tax liability actually imposed and its redetermined 
income tax liability are determined without taking into account the 
foreign tax credit under section 27(a) of the Internal Revenue Code.
    (3) Contents of statement and time of filing. The statement required 
under paragraph (c)(1) of this section must be included with or as part 
of the taxpayer's return for the year of the disposition or 
deconsolidation and must contain--
    (i) The name and employer identification number (E.I.N.) of the 
subsidiary; and
    (ii) The amount of the loss not disallowed under paragraph (a)(1) of 
this section by reason of this paragraph (c) and the amount of basis not 
reduced under paragraph (b)(1) of this section by reason of this 
paragraph (c).
    (4) Example. The principles of paragraphs (a), (b), and (c) of this 
section are illustrated by the examples in Sec. Sec. 1.337(d)-1(a)(5) 
and 1.1502-20(a)(5) (other than Examples 3, 4, and 5) and (b), with 
appropriate adjustments to reflect differences between the approach of 
this section and that of Sec. 1.1502-20, and by the following example. 
For purposes of the examples in this section, unless otherwise stated, 
the group files consolidated returns on a calendar year basis, the facts 
set forth the only corporate activity, and all sales and purchases are 
with unrelated buyers or sellers. The basis of each asset is the same 
for determining earnings and profits adjustments and taxable income. Tax 
liability and its effect on basis, value, and earnings and profits are 
disregarded. Investment adjustment system means the rules of Sec. 
1.1502-32. The example reads as follows:


[[Page 83]]


    Example. Loss offsetting built-in gain in a prior group. (i) P buys 
all the stock of T for $50 in Year 1, and T becomes a member of the P 
group. T has 2 assets. Asset 1 has a basis of $50 and a value of $0, and 
asset 2 has a basis of $0 and a value of $50. T sells asset 2 during 
Year 3 for $50 and recognizes a $50 gain. Under the investment 
adjustment system, P's basis in the T stock increased to $100 as a 
result of the recognition of gain. In Year 5, all of the stock of P is 
acquired by the P1 group, and the former members of the P group become 
members of the P1 group. T then sells asset 1 for $0, and recognizes a 
$50 loss. Under the investment adjustment system, P's basis in the T 
stock decreases to $50 as a result of the loss. T's assets decline in 
value from $50 to $40. P then sells all the stock of T for $40 and 
recognizes a $10 loss.
    (ii) P's basis in the T stock reflects both T's unrecognized gain 
and unrecognized loss with respect to its assets. The gain T recognizes 
on the disposition of asset 2 is built-in gain with respect to both the 
P and P1 groups for purposes of paragraph (c)(2) of this section. In 
addition, the loss T recognizes on the disposition of asset 1 is built-
in loss with respect to the P and P1 groups for purposes of paragraph 
(c)(2) of this section. T's recognition of the built-in loss while a 
member of the P1 group offsets the effect on T's stock basis of T's 
recognition of the built-in gain while a member of the P group. Thus, 
P's $10 loss on the sale of the T stock is not attributable to the 
recognition of built-in gain, and the loss is therefore not disallowed 
under paragraph (c)(2) of this section.
    (iii) The result would be the same if, instead of having a $50 
built-in loss in asset 1 when it becomes a member of the P group, T has 
a $50 net operating loss carryover and the carryover is used by the P 
group.

    (d) Successors. For purposes of this section, the rules and examples 
of Sec. 1.1502-20(d) apply, with appropriate adjustments to reflect 
differences between the approach of this section and that of Sec. 
1.1502-20.
    (e) Anti-avoidance rules. For purposes of this section, the rules 
and examples of Sec. 1.1502-20(e) apply, with appropriate adjustments 
to reflect differences between the approach of this section and that of 
Sec. 1.1502-20.
    (f) Investment adjustments. For purposes of this section, the rules 
and examples of Sec. 1.1502-20(f) apply, with appropriate adjustments 
to reflect differences between the approach of this section and that of 
Sec. 1.1502-20.
    (g) Effective dates. This section applies with respect to 
dispositions and deconsolidations on or after March 3, 2005. In 
addition, this section applies to dispositions and deconsolidations for 
which an election is made under Sec. 1.1502-20(i)(2) to determine 
allowable loss under this section. If loss is recognized because stock 
of a subsidiary became worthless, the disposition with respect to the 
stock is treated as occurring on the date the stock became worthless. 
For dispositions and deconsolidations after March 6, 2002 and before 
March 3, 2005, see Sec. 1.337(d)-2T as contained in the 26 CFR part 1 
in effect on March 2, 2005.

[70 FR 10322, Mar. 3, 2005, as amended by T.D. 9424, 73 FR 53947, Sept. 
17, 2008]



Sec. 1.337(d)-4  Taxable to tax-exempt.

    (a) Gain or loss recognition--(1) General rule. Except as provided 
in paragraph (b) of this section, if a taxable corporation transfers all 
or substantially all of its assets to one or more tax-exempt entities, 
the taxable corporation must recognize gain or loss immediately before 
the transfer as if the assets transferred were sold at their fair market 
values. But see section 267 and paragraph (d) of this section concerning 
limitations on the recognition of loss.
    (2) Change in corporation's tax status treated as asset transfer. 
Except as provided in paragraphs (a)(3) and (b) of this section, a 
taxable corporation's change in status to a tax-exempt entity will be 
treated as if it transferred all of its assets to a tax-exempt entity 
immediately before the change in status becomes effective in a 
transaction to which paragraph (a)(1) of this section applies. For 
example, if a State, a political subdivision thereof, or an entity any 
portion of whose income is excluded from gross income under section 115, 
acquires the stock of a taxable corporation and thereafter any of the 
taxable corporation's income is excluded from gross income under section 
115, the taxable corporation will be treated as if it transferred all of 
its assets to a tax-exempt entity immediately before the stock 
acquisition.
    (3) Exceptions for certain changes in status--(i) To whom available. 
Paragraph (a)(2) of this section does not apply to the following 
corporations--

[[Page 84]]

    (A) A corporation previously tax-exempt under section 501(a) which 
regains its tax-exempt status under section 501(a) within three years 
from the later of a final adverse adjudication on the corporation's tax 
exempt status, or the filing by the corporation, or by the Secretary or 
his delegate under section 6020(b), of a federal income tax return of 
the type filed by a taxable corporation;
    (B) A corporation previously tax-exempt under section 501(a) or that 
applied for but did not receive recognition of exemption under section 
501(a) before January 15, 1997, if such corporation is tax-exempt under 
section 501(a) within three years from January 28, 1999;
    (C) A newly formed corporation that is tax-exempt under section 
501(a) (other than an organization described in section 501(c)(7)) 
within three taxable years from the end of the taxable year in which it 
was formed;
    (D) A newly formed corporation that is tax-exempt under section 
501(a) as an organization described in section 501(c)(7) within seven 
taxable years from the end of the taxable year in which it was formed;
    (E) A corporation previously tax-exempt under section 501(a) as an 
organization described in section 501(c)(12), which, in a given taxable 
year or years prior to again becoming tax-exempt, is a taxable 
corporation solely because less than 85 percent of its income consists 
of amounts collected from members for the sole purpose of meeting losses 
and expenses; if, in a taxable year, such a corporation would be a 
taxable corporation even if 85 percent or more of its income consists of 
amounts collected from members for the sole purpose of meeting losses 
and expenses (a non-85 percent violation), paragraph (a)(3)(i)(A) of 
this section shall apply as if the corporation became a taxable 
corporation in its first taxable year that a non-85 percent violation 
occurred; or
    (F) A corporation previously taxable that becomes tax-exempt under 
section 501(a) as an organization described in section 501(c)(15) if 
during each taxable year in which it is described in section 501(c)(15) 
the organization is the subject of a court supervised rehabilitation, 
conservatorship, liquidation, or similar state proceeding; if such a 
corporation continues to be described in section 501(c)(15) in a taxable 
year when it is no longer the subject of a court supervised 
rehabilitation, conservatorship, liquidation, or similar state 
proceeding, paragraph (a)(2) of this section shall apply as if the 
corporation first became tax-exempt for such taxable year.
    (ii) Application for recognition. An organization is deemed to have 
or regain tax-exempt status within one of the periods described in 
paragraph (a)(3)(i)(A), (B), (C), or (D) of this section if it files an 
application for recognition of exemption with the Commissioner within 
the applicable period and the application either results in a 
determination by the Commissioner or a final adjudication that the 
organization is tax-exempt under section 501(a) during any part of the 
applicable period. The preceding sentence does not require the filing of 
an application for recognition of exemption by any organization not 
otherwise required, such as by Sec. Sec. 1.501(a)-1, 1.505(c)-1T, and 
1.508-1(a), to apply for recognition of exemption.
    (iii) Anti-abuse rule. This paragraph (a)(3) does not apply to a 
corporation that, with a principal purpose of avoiding the application 
of paragraph (a)(1) or (a)(2) of this section, acquires all or 
substantially all of the assets of another taxable corporation and then 
changes its status to that of a tax-exempt entity.
    (4) Related transactions. This section applies to any series of 
related transactions having an effect similar to any of the transactions 
to which this section applies.
    (b) Exceptions. Paragraph (a) of this section does not apply to--
    (1) Any assets transferred to a tax-exempt entity to the extent that 
the assets are used in an activity the income from which is subject to 
tax under section 511(a) (referred to hereinafter as a ``section 511(a) 
activity''). However, if assets used to any extent in a section 511(a) 
activity are disposed of by the tax-exempt entity, then, notwithstanding 
any other provision of law (except section 1031 or section 1033), any 
gain (not in excess of the amount

[[Page 85]]

not recognized by reason of the preceding sentence) shall be included in 
the tax-exempt entity's unrelated business taxable income. To the extent 
that the tax-exempt entity ceases to use the assets in a section 511(a) 
activity, the entity will be treated for purposes of this paragraph 
(b)(1) as having disposed of the assets on the date of the cessation for 
their fair market value. For purposes of paragraph (a)(1) of this 
section and this paragraph (b)(1)--
    (i) If during the first taxable year following the transfer of an 
asset or the corporation's change to tax-exempt status the asset will be 
used by the tax-exempt entity partly or wholly in a section 511(a) 
activity, the taxable corporation will recognize an amount of gain or 
loss that bears the same ratio to the asset's built-in gain or loss as 
100 percent reduced by the percentage of use for such taxable year in 
the section 511(a) activity bears to 100 percent. For purposes of 
determining the gain or loss, if any, to be recognized, the taxable 
corporation may rely on a written representation from the tax-exempt 
entity estimating the percentage of the asset's anticipated use in a 
section 511(a) activity for such taxable year, using a reasonable method 
of allocation, unless the taxable corporation has reason to believe that 
the tax-exempt entity's representation is not made in good faith;
    (ii) If for any taxable year the percentage of an asset's use in a 
section 511(a) activity decreases from the estimate used in computing 
gain or loss recognized under paragraph (b)(1)(i) of this section, 
adjusted for any decreases taken into account under this paragraph 
(b)(1)(ii) in prior taxable years, the tax-exempt entity shall recognize 
an amount of gain or loss that bears the same ratio to the asset's 
built-in gain or loss as the percentage point decrease in use in the 
section 511(a) activity for the taxable year bears to 100 percent;
    (iii) If property on which all or a portion of the gain or loss is 
not recognized by reason of the first sentence of paragraph (b)(1) of 
this section is disposed of in a transaction that qualifies for 
nonrecognition treatment under section 1031 or section 1033, the tax-
exempt entity must treat the replacement property as remaining subject 
to paragraph (b)(1) of this section to the extent that the exchanged or 
involuntarily converted property was so subject;
    (iv) The tax-exempt entity must use the same reasonable method of 
allocation for determining the percentage that it uses the assets in a 
section 511(a) activity as it uses for other tax purposes, such as 
determining the amount of depreciation deductions. The tax-exempt entity 
also must use this same reasonable method of allocation for each taxable 
year that it holds the assets; and
    (v) An asset's built-in gain or loss is the amount that would be 
recognized under paragraph (a)(1) of this section except for this 
paragraph (b)(1);
    (2) Any transfer of assets to the extent gain or loss otherwise is 
recognized by the taxable corporation on the transfer. See, for example, 
sections 336, 337(b)(2), 367, and 1001;
    (3) Any transfer of assets to the extent the transaction qualifies 
for nonrecognition treatment under section 1031 or section 1033; or
    (4) Any forfeiture of a taxable corporation's assets in a criminal 
or civil action to the United States, the government of a possession of 
the United States, a state, the District of Columbia, the government of 
a foreign country, or a political subdivision of any of the foregoing; 
or any expropriation of a taxable corporation's assets by the government 
of a foreign country.
    (c) Definitions. For purposes of this section:
    (1) Taxable corporation. A taxable corporation is any corporation 
that is not a tax-exempt entity as defined in paragraph (c)(2) of this 
section.
    (2) Tax-exempt entity. A tax-exempt entity is--
    (i) Any entity that is exempt from tax under section 501(a) or 
section 529;
    (ii) A charitable remainder annuity trust or charitable remainder 
unitrust as defined in section 664(d);
    (iii) The United States, the government of a possession of the 
United States, a state, the District of Columbia, the government of a 
foreign country, or a political subdivision of any of the foregoing;

[[Page 86]]

    (iv) An Indian Tribal Government as defined in section 7701(a)(40), 
a subdivision of an Indian Tribal Government determined in accordance 
with section 7871(d), or an agency or instrumentality of an Indian 
Tribal Government or subdivision thereof;
    (v) An Indian Tribal Corporation organized under section 17 of the 
Indian Reorganization Act of 1934, 25 U.S.C. 477, or section 3 of the 
Oklahoma Welfare Act, 25 U.S.C. 503;
    (vi) An international organization as defined in section 
7701(a)(18);
    (vii) An entity any portion of whose income is excluded under 
section 115; or
    (viii) An entity that would not be taxable under the Internal 
Revenue Code for reasons substantially similar to those applicable to 
any entity listed in this paragraph (c)(2) unless otherwise explicitly 
made exempt from the application of this section by statute or by action 
of the Commissioner.
    (3) Substantially all. The term substantially all has the same 
meaning as under section 368(a)(1)(C).
    (d) Loss limitation rule. For purposes of determining the amount of 
gain or loss recognized by a taxable corporation on the transfer of its 
assets to a tax-exempt entity under paragraph (a) of this section, if 
assets are acquired by the taxable corporation in a transaction to which 
section 351 applied or as a contribution to capital, or assets are 
distributed from the taxable corporation to a shareholder or another 
member of the taxable corporation's affiliated group, and in either case 
such acquisition or distribution is made as part of a plan a principal 
purpose of which is to recognize loss by the taxable corporation on the 
transfer of such assets to the tax-exempt entity, the losses recognized 
by the taxable corporation on such assets transferred to the tax-exempt 
entity will be disallowed. For purposes of the preceding sentence, the 
principles of section 336(d)(2) apply.
    (e) Effective date. This section is applicable to transfers of 
assets as described in paragraph (a) of this section occurring after 
January 28, 1999, unless the transfer is pursuant to a written agreement 
which is (subject to customary conditions) binding on or before January 
28, 1999.

[T.D. 8802, 63 FR 71594, Dec. 29, 1998]



Sec. 1.337(d)-5  Old transitional rules imposing tax on 

property owned by a C corporation that becomes property of a RIC or REIT

    (a) Treatment of C corporations--(1) Scope. This section applies to 
the net built-in gain of C corporation assets that become assets of a 
RIC or REIT by--
    (i) The qualification of a C corporation as a RIC or REIT; or
    (ii) The transfer of assets of a C corporation to a RIC or REIT in a 
transaction in which the basis of such assets are determined by 
reference to the C corporation's basis (a carryover basis).
    (2) Net built-in gain. Net built-in gain is the excess of aggregate 
gains (including items of income) over aggregate losses.
    (3) General rule. Unless an election is made pursuant to paragraph 
(b) of this section, the C corporation will be treated, for all purposes 
including recognition of net built-in gain, as if it had sold all of its 
assets at their respective fair market values on the deemed liquidation 
date described in paragraph (a)(7) of this section and immediately 
liquidated.
    (4) Loss. Paragraph (a)(3) of this section shall not apply if its 
application would result in the recognition of net built-in loss.
    (5) Basis adjustment. If a corporation is subject to corporate-level 
tax under paragraph (a)(3) of this section, the bases of the assets in 
the hands of the RIC or REIT will be adjusted to reflect the recognized 
net built-in gain. This adjustment is made by taking the C corporation's 
basis in each asset, and, as appropriate, increasing it by the amount of 
any built-in gain attributable to that asset, or decreasing it by the 
amount of any built-in loss attributable to that asset.
    (6) Exception--(i) In general. Paragraph (a)(3) of this section does 
not apply to any C corporation that--
    (A) Immediately prior to qualifying to be taxed as a RIC was subject 
to tax as a C corporation for a period not exceeding one taxable year; 
and

[[Page 87]]

    (B) Immediately prior to being subject to tax as a C corporation was 
subject to the RIC tax provisions for a period of at least one taxable 
year.
    (ii) Additional requirement. The exception described in paragraph 
(a)(6)(i) of this section applies only to assets acquired by the 
corporation during the year when it was subject to tax as a C 
corporation in a transaction that does not result in its basis in the 
asset being determined by reference to a corporate transferor's basis.
    (7) Deemed liquidation date--(i) Conversions. In the case of a C 
corporation that qualifies to be taxed as a RIC or REIT, the deemed 
liquidation date is the last day of its last taxable year before the 
taxable year in which it qualifies to be taxed as a RIC or REIT.
    (ii) Carryover basis transfers. In the case of a C corporation that 
transfers property to a RIC or REIT in a carryover basis transaction, 
the deemed liquidation date is the day before the date of the transfer.
    (b) Section 1374 treatment--(1) In general. Paragraph (a) of this 
section will not apply if the transferee RIC or REIT elects (as 
described in paragraph (b)(3) of this section) to be subject to the 
rules of section 1374, and the regulations thereunder. The electing RIC 
or REIT will be subject to corporate-level taxation on the built-in gain 
recognized during the 10-year period on assets formerly held by the 
transferor C corporation. The built-in gains of electing RICs and REITs, 
and the corporate-level tax imposed on such gains, are subject to rules 
similar to the rules relating to net income from foreclosure property of 
REITs. See sections 857(a)(1)(A)(ii), and 857(b)(2)(B), (D), and (E). An 
election made under this paragraph (b) shall be irrevocable.
    (2) Ten-year recognition period. In the case of a C corporation that 
qualifies to be taxed as a RIC or REIT, the 10-year recognition period 
described in section 1374(d)(7) begins on the first day of the RIC's or 
REIT's taxable year for which the corporation qualifies to be taxed as a 
RIC or REIT. In the case of a C corporation that transfers property to a 
RIC or REIT in a carryover basis transaction, the 10-year recognition 
period begins on the day the assets are acquired by the RIC or REIT.
    (3) Making the election. A RIC or REIT validly makes a section 1374 
election with the following statement: ``[Insert name and employer 
identification number of electing RIC or REIT] elects under paragraph 
(b) of this section to be subject to the rules of section 1374 and the 
regulations thereunder with respect to its assets which formerly were 
held by a C corporation, [insert name and employer identification number 
of the C corporation, if different from name and employer identification 
number of RIC or REIT].'' This statement must be signed by an official 
authorized to sign the income tax return of the RIC or REIT and attached 
to the RIC's or REIT's Federal income tax return for the first taxable 
year in which the assets of the C corporation become assets of the RIC 
or REIT.
    (c) Special rule. In cases where the first taxable year in which the 
assets of the C corporation become assets of the RIC or REIT ends after 
June 10, 1987 but before March 8, 2000, the section 1374 election may be 
filed with the first Federal income tax return filed by the RIC or REIT 
after March 8, 2000.
    (d) Effective date. In the case of carryover basis transactions 
involving the transfer of property of a C corporation to a RIC or REIT, 
the regulations apply to transactions occurring on or after June 10, 
1987, and before January 2, 2002. In the case of a C corporation that 
qualifies to be taxed as a RIC or REIT, the regulations apply to such 
qualifications that are effective for taxable years beginning on or 
after June 10, 1987, and before January 2, 2002. However, RICs and REITs 
that are subject to section 1374 treatment under this section may not 
rely on paragraph (b)(1) of this section, but must apply paragraphs 
(c)(1)(i), (c)(2)(i), (c)(2)(ii), and (c)(3) of Sec. 1.337(d)-6, with 
respect to built-in gains and losses recognized in taxable years 
beginning on or after January 2, 2002. In lieu of applying this section, 
taxpayers may rely on Sec. 1.337(d)-6 to determine the tax consequences 
(for all taxable years) of any conversion transaction. For transactions 
and qualifications that occur

[[Page 88]]

on or after January 2, 2002, see Sec. 1.337(d)-7.

[T.D. 8872, 65 FR 5776, Feb. 7, 2000, as amended by T.D. 8975, 67 FR 12, 
Jan. 2, 2002. Redesignated and amended by T.D. 9047, 68 FR 12819, Mar. 
19, 2003]



Sec. 1.337(d)-6  New transitional rules imposing tax on property 

owned by a C corporation that becomes property of a RIC or REIT.

    (a) General rule--(1) Property owned by a C corporation that becomes 
property of a RIC or REIT. If property owned by a C corporation (as 
defined in paragraph (a)(2)(i) of this section) becomes the property of 
a RIC or REIT (the converted property) in a conversion transaction (as 
defined in paragraph (a)(2)(ii) of this section), then deemed sale 
treatment will apply as described in paragraph (b) of this section, 
unless the RIC or REIT elects section 1374 treatment with respect to the 
conversion transaction as provided in paragraph (c) of this section. See 
paragraph (d) of this section for exceptions to this paragraph (a).
    (2) Definitions--(i) C corporation. For purposes of this section, 
the term C corporation has the meaning provided in section 1361(a)(2) 
except that the term does not include a RIC or REIT.
    (ii) Conversion transaction. For purposes of this section, the term 
conversion transaction means the qualification of a C corporation as a 
RIC or REIT or the transfer of property owned by a C corporation to a 
RIC or REIT.
    (b) Deemed sale treatment--(1) In general. If property owned by a C 
corporation becomes the property of a RIC or REIT in a conversion 
transaction, then the C corporation recognizes gain and loss as if it 
sold the converted property to an unrelated party at fair market value 
on the deemed sale date (as defined in paragraph (b)(3) of this 
section). This paragraph (b) does not apply if its application would 
result in the recognition of a net loss. For this purpose, net loss is 
the excess of aggregate losses over aggregate gains (including items of 
income), without regard to character.
    (2) Basis adjustment. If a corporation recognizes a net gain under 
paragraph (b)(1) of this section, then the converted property has a 
basis in the hands of the RIC or REIT equal to the fair market value of 
such property on the deemed sale date.
    (3) Deemed sale date--(i) RIC or REIT qualifications. If the 
conversion transaction is a qualification of a C corporation as a RIC or 
REIT, then the deemed sale date is the end of the last day of the C 
corporation's last taxable year before the first taxable year in which 
it qualifies to be taxed as a RIC or REIT.
    (ii) Other conversion transactions. If the conversion transaction is 
a transfer of property owned by a C corporation to a RIC or REIT, then 
the deemed sale date is the end of the day before the day of the 
transfer.
    (4) Example. The rules of this paragraph (b) are illustrated by the 
following example:

    Example. Deemed sale treatment on merger into RIC. (i) X, a 
calendar-year taxpayer, has qualified as a RIC since January 1, 1991. On 
May 31, 1994, Y, a C corporation and calendar-year taxpayer, transfers 
all of its property to X in a transaction that qualifies as a 
reorganization under section 368(a)(1)(C). X does not elect section 1374 
treatment under paragraph (c) of this section and chooses not to rely on 
Sec. 1.337(d)-5. As a result of the transfer, Y is subject to deemed 
sale treatment under this paragraph (b) on its tax return for the short 
taxable year ending May 31, 1994. On May 31, 1994, Y's only assets are 
Capital Asset, which has a fair market value of $100,000 and a basis of 
$40,000 as of the end of May 30, 1994, and $50,000 cash. Y also has an 
unrestricted net operating loss carryforward of $12,000 and accumulated 
earnings and profits of $50,000. Y has no taxable income for the short 
taxable year ending May 31, 1994, other than gain recognized under this 
paragraph (b). In 1997, X sells Capital Asset for $110,000. Assume the 
applicable corporate tax rate is 35%.
    (ii) Under this paragraph (b), Y is treated as if it sold the 
converted property (Capital Asset and $50,000 cash) at fair market value 
on May 30, 1994, recognizing $60,000 of gain ($150,000 amount realized--
$90,000 basis). Y must report the gain on its tax return for the short 
taxable year ending May 31, 1994. Y may offset this gain with its 
$12,000 net operating loss carryforward and will pay tax of $16,800 (35% 
of $48,000).
    (iii) Under section 381, X succeeds to Y's accumulated earnings and 
profits. Y's accumulated earnings and profits of $50,000 increase by 
$60,000 and decrease by $16,800 as a result of the deemed sale. Thus, 
the aggregate amount of subchapter C earnings and profits that must be 
distributed to satisfy section 852(a)(2)(B) is $93,200 ($50,000 + 
$60,000 - $16,800). X's basis in Capital Asset is

[[Page 89]]

$100,000. On X's sale of Capital Asset in 1997, X recognizes $10,000 of 
gain, which is taken into account in computing X's net capital gain for 
purposes of section 852(b)(3).

    (c) Election of section 1374 treatment--(1) In general--(i) Property 
owned by a C corporation that becomes property of a RIC or REIT. 
Paragraph (b) of this section does not apply if the RIC or REIT that was 
formerly a C corporation or that acquired property from a C corporation 
makes the election described in paragraph (c)(4) of this section. A RIC 
or REIT that makes such an election will be subject to tax on the net 
built-in gain in the converted property under the rules of section 1374 
and the regulations thereunder, as modified by this paragraph (c), as if 
the RIC or REIT were an S corporation.
    (ii) Property subject to the rules of section 1374 owned by a RIC, 
REIT, or S corporation that becomes property of a RIC or REIT. If 
property subject to the rules of section 1374 owned by a RIC, a REIT, or 
an S corporation (the predecessor) becomes the property of a RIC or REIT 
(the successor) in a continuation transaction, the rules of section 1374 
apply to the successor to the same extent that the predecessor was 
subject to the rules of section 1374 with respect to such property, and 
the 10-year recognition period of the successor with respect to such 
property is reduced by the portion of the 10-year recognition period of 
the predecessor that expired before the date of the continuation 
transaction. For this purpose, a continuation transaction means the 
qualification of the predecessor as a RIC or REIT or the transfer of 
property from the predecessor to the successor in a transaction in which 
the successor's basis in the transferred property is determined, in 
whole or in part, by reference to the predecessor's basis in that 
property.
    (2) Modification of section 1374 treatment--(i) Net recognized 
built-in gain for REITs--(A) Prelimitation amount. The prelimitation 
amount determined as provided in Sec. 1.1374-2(a)(1) is reduced by the 
portion of such amount, if any, that is subject to tax under section 
857(b)(4), (5), (6), or (7). For this purpose, the amount of a REIT's 
recognized built-in gain that is subject to tax under section 857(b)(5) 
is computed as follows:
    (1) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(A), the amount of a REIT's recognized built-in gain 
that is subject to tax under section 857(b)(5) is the tax imposed by 
section 857(b)(5) multiplied by a fraction the numerator of which is the 
amount of recognized built-in gain (without regard to recognized built-
in loss and recognized built-in gain from prohibited transactions) that 
is not derived from sources referred to in section 856(c)(2) and the 
denominator of which is the gross income (without regard to gross income 
from prohibited transactions) of the REIT that is not derived from 
sources referred to in section 856(c)(2).
    (2) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(B), the amount of a REIT's recognized built-in gain 
that is subject to tax under section 857(b)(5) is the tax imposed by 
section 857(b)(5) multiplied by a fraction the numerator of which is the 
amount of recognized built-in gain (without regard to recognized built-
in loss and recognized built-in gain from prohibited transactions) that 
is not derived from sources referred to in section 856(c)(3) and the 
denominator of which is the gross income (without regard to gross income 
from prohibited transactions) of the REIT that is not derived from 
sources referred to in section 856(c)(3).
    (B) Taxable income limitation. The taxable income limitation 
determined as provided in Sec. 1.1374-2(a)(2) is reduced by an amount 
equal to the tax imposed under sections 857(b)(5), (6), and (7).
    (ii) Loss carryforwards, credits and credit carryforwards--(A) Loss 
carryforwards. Consistent with paragraph (c)(1)(i) of this section, net 
operating loss carryforwards and capital loss carryforwards arising in 
taxable years for which the corporation that generated the loss was not 
subject to subchapter M of chapter 1 of the Internal Revenue Code are 
allowed as a deduction against net recognized built-in gain to the 
extent allowed under section 1374 and the regulations thereunder. Such 
loss carryforwards must be used as a deduction against net recognized 
built-in gain for a taxable year to

[[Page 90]]

the greatest extent possible before such losses can be used to reduce 
other investment company taxable income for purposes of section 852(b) 
or other real estate investment trust taxable income for purposes of 
section 857(b) for that taxable year.
    (B) Credits and credit carryforwards. Consistent with paragraph 
(c)(1)(i) of this section, minimum tax credits and business credit 
carryforwards arising in taxable years for which the corporation that 
generated the credit was not subject to subchapter M of chapter 1 of the 
Internal Revenue Code are allowed to reduce the tax imposed on net 
recognized built-in gain under this paragraph (c) to the extent allowed 
under section 1374 and the regulations thereunder. Such credits and 
credit carryforwards must be used to reduce the tax imposed under this 
paragraph (c) on net recognized built-in gain for a taxable year to the 
greatest extent possible before such credits and credit carryforwards 
can be used to reduce the tax, if any, on other investment company 
taxable income for purposes of section 852(b) or on other real estate 
investment trust taxable income for purposes of section 857(b) for that 
taxable year.
    (iii) 10-year recognition period. In the case of a conversion 
transaction that is a qualification of a C corporation as a RIC or REIT, 
the 10-year recognition period described in section 1374(d)(7) begins on 
the first day of the RIC's or REIT's first taxable year. In the case of 
other conversion transactions, the 10-year recognition period begins on 
the day the property is acquired by the RIC or REIT.
    (3) Coordination with subchapter M rules--(i) Recognized built-in 
gains and losses subject to subchapter M. Recognized built-in gains and 
losses of a RIC or REIT are included in computing investment company 
taxable income for purposes of section 852(b)(2), real estate investment 
trust taxable income for purposes of section 857(b)(2), capital gains 
for purposes of sections 852(b)(3) and 857(b)(3), gross income derived 
from sources within any foreign country or possession of the United 
States for purposes of section 853, and the dividends paid deduction for 
purposes of sections 852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B), and 
857(b)(3)(A). In computing such income and deduction items, capital loss 
carryforwards and net operating loss carryforwards that are used by the 
RIC or REIT to reduce recognized built-in gains are allowed as a 
deduction, but only to the extent that they are otherwise allowable as a 
deduction against such income under the Internal Revenue Code (including 
section 852(b)(2)(B)).
    (ii) Treatment of tax imposed. The amount of tax imposed under this 
paragraph (c) on net recognized built-in gain for a taxable year is 
treated as a loss sustained by the RIC or the REIT during such taxable 
year. The character of the loss is determined by allocating the tax 
proportionately (based on recognized built-in gain) among the items of 
recognized built-in gain included in net recognized built-in gain. With 
respect to RICs, the tax imposed under this paragraph (c) on net 
recognized built-in gain is treated as attributable to the portion of 
the RIC's taxable year occurring after October 31.
    (4) Making the section 1374 election--(i) In general. A RIC or REIT 
makes a section 1374 election with the following statement: ``[Insert 
name and employer identification number of electing RIC or REIT] elects 
under Sec. 1.337-6(c) to be subject to the rules of section 1374 and 
the regulations thereunder with respect to its property that formerly 
was held by a C corporation, [insert name and employer identification 
number of the C corporation, if different from name and employer 
identification number of the RIC or REIT].'' However, a RIC or REIT need 
not file an election under this paragraph (c), but will be deemed to 
have made such an election if it can demonstrate that it informed the 
Internal Revenue Service prior to January 2, 2002 of its intent to make 
a section 1374 election. An election under this paragraph (c) is 
irrevocable.
    (ii) Time for making the election. An election under this paragraph 
(c) may be filed by the RIC or REIT with any Federal income tax return 
filed by the RIC or REIT on or before September 15, 2003, provided that 
the RIC or REIT has reported consistently with such election for all 
periods.

[[Page 91]]

    (5) Example. The rules of this paragraph (c) are illustrated by the 
following example:

    Example. Section 1374 treatment on REIT election. (i) X, a C 
corporation that is a calendar-year taxpayer, elects to be taxed as a 
REIT on its 1994 tax return, which it files on March 15, 1995. As a 
result, X is a REIT for its 1994 taxable year and would be subject to 
deemed sale treatment under paragraph (b) of this section but for X's 
timely election of section 1374 treatment under this paragraph (c). X 
chooses not to rely on Sec. 1.337(d)-5. As of the beginning of the 1994 
taxable year, X's property consisted of Real Property, which is not 
section 1221(a)(1) property and which had a fair market value of 
$100,000 and an adjusted basis of $80,000, and $25,000 cash. X also had 
accumulated earnings and profits of $25,000, unrestricted capital loss 
carryforwards of $3,000, and unrestricted business credit carryforwards 
of $2,000. On July 1, 1997, X sells Real Property for $110,000. For its 
1997 taxable year, X has no other income or deduction items. Assume the 
highest corporate tax rate is 35%.
    (ii) Upon its election to be taxed as a REIT, X retains its $80,000 
basis in Real Property and its $25,000 accumulated earnings and profits. 
X retains its $3,000 of capital loss carryforwards and its $2,000 of 
business credit carryforwards. To satisfy section 857(a)(2)(B), X must 
distribute $25,000, an amount equal to its earnings and profits 
accumulated in non-REIT years, to its shareholders by the end of its 
1994 taxable year.
    (iii) Upon X's sale of Real Property in 1997, X recognizes gain of 
$30,000 ($110,000--$80,000). X's recognized built-in gain for purposes 
of applying section 1374 is $20,000 ($100,000 fair market value as of 
the beginning of X's first taxable year as a REIT--$80,000 basis). 
Because X's $30,000 of net income for the 1997 taxable year exceeds the 
net recognized built-in gain of $20,000, the taxable income limitation 
does not apply. X, therefore, has $20,000 net recognized built-in gain 
for the year. Assuming that X has not used its $3,000 of capital loss 
carryforwards in a prior taxable year and that their use is allowed 
under section 1374(b)(2) and Sec. 1.1374-5, X is allowed a $3,000 
deduction against the $20,000 net recognized built-in gain. X would owe 
tax of $5,950 (35% of $17,000) on its net recognized built-in gain, 
except that X may use its $2,000 of business credit carryforwards to 
reduce this tax, assuming that X has not used the credit carryforwards 
in a prior taxable year and that their use is allowed under section 
1374(b)(3) and Sec. 1.1374-6. Thus, X owes tax of $3,950 under this 
paragraph (c).
    (iv) For purposes of subchapter M of chapter 1 of the Internal 
Revenue Code, X's earnings and profits for the year increase by $26,050 
($30,000 capital gain on the sale of Real Property--$3,950 tax under 
this paragraph (c)). For purposes of section 857(b)(2) and (b)(3), X's 
net capital gain for the year is $23,050 ($30,000 capital gain reduced 
by $3,000 capital loss carryforward and further reduced by $3,950 tax).

    (d) Exceptions--(1) Gain otherwise recognized. Paragraph (a) of this 
section does not apply to any conversion transaction to the extent that 
gain or loss otherwise is recognized on such conversion transaction. 
See, for example, sections 336, 351(b), 351(e), 356, 357(c), 367, 
368(a)(2)(F), and 1001.
    (2) Re-election of RIC or REIT status--(i) Generally. Except as 
provided in paragraphs (d)(2)(ii) and (iii) of this section, paragraph 
(a)(1) of this section does not apply to any corporation that--
    (A) Immediately prior to qualifying to be taxed as a RIC or REIT was 
subject to tax as a C corporation for a period not exceeding two taxable 
years; and
    (B) Immediately prior to being subject to tax as a C corporation was 
subject to tax as a RIC or REIT for a period of at least one taxable 
year.
    (ii) Property acquired from another corporation while a C 
corporation. The exception described in paragraph (d)(2)(i) of this 
section does not apply to property acquired by the corporation while it 
was subject to tax as a C corporation from any person in a transaction 
that results in the acquirer's basis in the property being determined by 
reference to a C corporation's basis in the property.
    (iii) RICs and REITs previously subject to section 1374 treatment. 
If the RIC or REIT had property subject to paragraph (c) of this section 
before the RIC or REIT became subject to tax as a C corporation as 
described in paragraph (d)(2)(i) of this section, then paragraph (c) of 
this section applies to the RIC or REIT upon its requalification as a 
RIC or REIT, except that the 10-year recognition period with respect to 
such property is reduced by the portion of the 10-year recognition 
period that expired before the RIC or REIT became subject to tax as a C 
corporation and by the period of time that the corporation was subject 
to tax as a C corporation.
    (e) Effective date. This section applies to conversion transactions 
that occur

[[Page 92]]

on or after June 10, 1987, and before January 2, 2002. In lieu of 
applying this section, taxpayers generally may apply Sec. 1.337(d)-5 to 
determine the tax consequences (for all taxable years) of any conversion 
transaction that occurs on or after June 10, 1987 and before January 2, 
2002, except that RICs and REITs that are subject to section 1374 
treatment with respect to a conversion transaction may not rely on Sec. 
1.337(d)-5(b)(1), but must apply paragraphs (c)(1)(i), (c)(2)(i), 
(c)(2)(ii), and (c)(3) of this section, with respect to built-in gains 
and losses recognized in taxable years beginning on or after January 2, 
2002. Taxpayers are not prevented from relying on Sec. 1.337(d)-5 
merely because they elect section 1374 treatment in the manner described 
in paragraph (c)(4) of this section instead of in the manner described 
in Sec. 1.337(d)-5(b)(3) and (c). For conversion transactions that 
occur on or after January 2, 2002, see Sec. 1.337(d)-7.

[T.D. 9047, 68 FR 12820, Mar. 18, 2003]



Sec. 1.337(d)-7  Tax on property owned by a C corporation that becomes 

property of a RIC or REIT.

    (a) General rule--(1) Property owned by a C corporation that becomes 
property of a RIC or REIT. If property owned by a C corporation (as 
defined in paragraph (a)(2)(i) of this section) becomes the property of 
a RIC or REIT (the converted property) in a conversion transaction (as 
defined in paragraph (a)(2)(ii) of this section), then section 1374 
treatment will apply as described in paragraph (b) of this section, 
unless the C corporation elects deemed sale treatment with respect to 
the conversion transaction as provided in paragraph (c) of this section. 
See paragraph (d) of this section for exceptions to this paragraph (a).
    (2) Definitions--(i) C corporation. For purposes of this section, 
the term C corporation has the meaning provided in section 1361(a)(2) 
except that the term does not include a RIC or REIT.
    (ii) Conversion transaction. For purposes of this section, the term 
conversion transaction means the qualification of a C corporation as a 
RIC or REIT or the transfer of property owned by a C corporation to a 
RIC or REIT.
    (b) Section 1374 treatment--(1) In general--(i) Property owned by a 
C corporation that becomes property of a RIC or REIT. If property owned 
by a C corporation becomes the property of a RIC or REIT in a conversion 
transaction, then the RIC or REIT will be subject to tax on the net 
built-in gain in the converted property under the rules of section 1374 
and the regulations thereunder, as modified by this paragraph (b), as if 
the RIC or REIT were an S corporation.
    (ii) Property subject to the rules of section 1374 owned by a RIC, 
REIT, or S corporation that becomes property of a RIC or REIT. If 
property subject to the rules of section 1374 owned by a RIC, a REIT, or 
an S corporation (the predecessor) becomes the property of a RIC or REIT 
(the successor) in a continuation transaction, the rules of section 1374 
apply to the successor to the same extent that the predecessor was 
subject to the rules of section 1374 with respect to such property, and 
the 10-year recognition period of the successor with respect to such 
property is reduced by the portion of the 10-year recognition period of 
the predecessor that expired before the date of the continuation 
transaction. For this purpose, a continuation transaction means the 
qualification of the predecessor as a RIC or REIT or the transfer of 
property from the predecessor to the successor in a transaction in which 
the successor's basis in the transferred property is determined, in 
whole or in part, by reference to the predecessor's basis in that 
property.
    (2) Modification of section 1374 treatment--(i) Net recognized 
built-in gain for REITs--(A) Prelimitation amount. The prelimitation 
amount determined as provided in Sec. 1.1374-2(a)(1) is reduced by the 
portion of such amount, if any, that is subject to tax under section 
857(b)(4), (5), (6), or (7). For this purpose, the amount of a REIT's 
recognized built-in gain that is subject to tax under section 857(b)(5) 
is computed as follows:
    (1) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(A), the amount of a REIT's recognized built-in gain 
that is subject to tax under section 857(b)(5) is the tax imposed by 
section 857(b)(5)

[[Page 93]]

multiplied by a fraction the numerator of which is the amount of 
recognized built-in gain (without regard to recognized built-in loss and 
recognized built-in gain from prohibited transactions) that is not 
derived from sources referred to in section 856(c)(2) and the 
denominator of which is the gross income (without regard to gross income 
from prohibited transactions) of the REIT that is not derived from 
sources referred to in section 856(c)(2).
    (2) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(B), the amount of a REIT's recognized built-in gain 
that is subject to tax under section 857(b)(5) is the tax imposed by 
section 857(b)(5) multiplied by a fraction the numerator of which is the 
amount of recognized built-in gain (without regard to recognized built-
in loss and recognized built-in gain from prohibited transactions) that 
is not derived from sources referred to in section 856(c)(3) and the 
denominator of which is the gross income (without regard to gross income 
from prohibited transactions) of the REIT that is not derived from 
sources referred to in section 856(c)(3).
    (B) Taxable income limitation. The taxable income limitation 
determined as provided in Sec. 1.1374-2(a)(2) is reduced by an amount 
equal to the tax imposed under section 857(b)(5), (6), and (7).
    (ii) Loss carryforwards, credits and credit carryforwards--(A) Loss 
carryforwards. Consistent with paragraph (b)(1)(i) of this section, net 
operating loss carryforwards and capital loss carryforwards arising in 
taxable years for which the corporation that generated the loss was not 
subject to subchapter M of chapter 1 of the Internal Revenue Code are 
allowed as a deduction against net recognized built-in gain to the 
extent allowed under section 1374 and the regulations thereunder. Such 
loss carryforwards must be used as a deduction against net recognized 
built-in gain for a taxable year to the greatest extent possible before 
such losses can be used to reduce other investment company taxable 
income for purposes of section 852(b) or other real estate investment 
trust taxable income for purposes of section 857(b) for that taxable 
year.
    (B) Credits and credit carryforwards. Consistent with paragraph 
(b)(1)(i) of this section, minimum tax credits and business credit 
carryforwards arising in taxable years for which the corporation that 
generated the credit was not subject to subchapter M of chapter 1 of the 
Internal Revenue Code are allowed to reduce the tax imposed on net 
recognized built-in gain under this paragraph (b) to the extent allowed 
under section 1374 and the regulations thereunder. Such credits and 
credit carryforwards must be used to reduce the tax imposed under this 
paragraph (b) on net recognized built-in gain for a taxable year to the 
greatest extent possible before such credits and credit carryforwards 
can be used to reduce the tax, if any, on other investment company 
taxable income for purposes of section 852(b) or on other real estate 
investment trust taxable income for purposes of section 857(b) for that 
taxable year.
    (iii) 10-year recognition period. In the case of a conversion 
transaction that is a qualification of a C corporation as a RIC or REIT, 
the 10-year recognition period described in section 1374(d)(7) begins on 
the first day of the RIC's or REIT's first taxable year. In the case of 
other conversion transactions, the 10-year recognition period begins on 
the day the property is acquired by the RIC or REIT.
    (3) Coordination with subchapter M rules--(i) Recognized built-in 
gains and losses subject to subchapter M. Recognized built-in gains and 
losses of a RIC or REIT are included in computing investment company 
taxable income for purposes of section 852(b)(2), real estate investment 
trust taxable income for purposes of section 857(b)(2), capital gains 
for purposes of sections 852(b)(3) and 857(b)(3), gross income derived 
from sources within any foreign country or possession of the United 
States for purposes of section 853, and the dividends paid deduction for 
purposes of sections 852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B), and 
857(b)(3)(A). In computing such income and deduction items, capital loss 
carryforwards and net operating loss carryforwards that are used by the 
RIC or REIT to reduce recognized built-in gains are allowed as a 
deduction, but only to the extent

[[Page 94]]

that they are otherwise allowable as a deduction against such income 
under the Internal Revenue Code (including section 852(b)(2)(B)).
    (ii) Treatment of tax imposed. The amount of tax imposed under this 
paragraph (b) on net recognized built-in gain for a taxable year is 
treated as a loss sustained by the RIC or the REIT during such taxable 
year. The character of the loss is determined by allocating the tax 
proportionately (based on recognized built-in gain) among the items of 
recognized built-in gain included in net recognized built-in gain. With 
respect to RICs, the tax imposed under this paragraph (b) on net 
recognized built-in gain is treated as attributable to the portion of 
the RIC's taxable year occurring after October 31.
    (4) Example. The rules of this paragraph (b) are illustrated by the 
following example:

    Example. Section 1374 treatment on REIT election. (i) X, a C 
corporation that is a calendar-year taxpayer, elects to be taxed as a 
REIT on its 2004 tax return, which it files on March 15, 2005. As a 
result, X is a REIT for its 2004 taxable year and is subject to section 
1374 treatment under this paragraph (b). X does not elect deemed sale 
treatment under paragraph (c) of this section. As of the beginning of 
the 2004 taxable year, X's property consisted of Real Property, which is 
not section 1221(a)(1) property and which had a fair market value of 
$100,000 and an adjusted basis of $80,000, and $25,000 cash. X also had 
accumulated earnings and profits of $25,000, unrestricted capital loss 
carryforwards of $3,000, and unrestricted business credit carryforwards 
of $2,000. On July 1, 2007, X sells Real Property for $110,000. For its 
2007 taxable year, X has no other income or deduction items. Assume the 
highest corporate tax rate is 35%.
    (ii) Upon its election to be taxed as a REIT, X retains its $80,000 
basis in Real Property and its $25,000 accumulated earnings and profits. 
X retains its $3,000 of capital loss carryforwards and its $2,000 of 
business credit carryforwards. To satisfy section 857(a)(2)(B), X must 
distribute $25,000, an amount equal to its earnings and profits 
accumulated in non-REIT years, to its shareholders by the end of its 
2004 taxable year.
    (iii) Upon X's sale of Real Property in 2007, X recognizes gain of 
$30,000 ($110,000--$80,000). X's recognized built-in gain for purposes 
of applying section 1374 is $20,000 ($100,000 fair market value as of 
the beginning of X's first taxable year as a REIT--$80,000 basis). 
Because X's $30,000 of net income for the 2007 taxable year exceeds the 
net recognized built-in gain of $20,000, the taxable income limitation 
does not apply. X, therefore, has $20,000 net recognized built-in gain 
for the year. Assuming that X has not used its $3,000 of capital loss 
carryforwards in a prior taxable year and that their use is allowed 
under section 1374(b)(2) and Sec. 1.1374-5, X is allowed a $3,000 
deduction against the $20,000 net recognized built-in gain. X would owe 
tax of $5,950 (35% of $17,000) on its net recognized built-in gain, 
except that X may use its $2,000 of business credit carryforwards to 
reduce the tax, assuming that X has not used the credit carryforwards in 
a prior taxable year and that their use is allowed under section 
1374(b)(3) and Sec. 1.1374-6. Thus, X owes tax of $3,950 under this 
paragraph (b).
    (iv) For purposes of subchapter M of chapter 1 of the Internal 
Revenue Code, X's earnings and profits for the year increase by $26,050 
($30,000 capital gain on the sale of Real Property--$3,950 tax under 
this paragraph (b)). For purposes of section 857(b)(2) and (b)(3), X's 
net capital gain for the year is $23,050 ($30,000 capital gain reduced 
by $3,000 capital loss carryforward and further reduced by $3,950 tax).

    (c) Election of deemed sale treatment--(1) In general. Paragraph (b) 
of this section does not apply if the C corporation that qualifies as a 
RIC or REIT or transfers property to a RIC or REIT makes the election 
described in paragraph (c)(5) of this section. A C corporation that 
makes such an election recognizes gain and loss as if it sold the 
converted property to an unrelated party at fair market value on the 
deemed sale date (as defined in paragraph (c)(3) of this section). See 
paragraph (c)(4) of this section concerning limitations on the use of 
loss in computing gain. This paragraph (c) does not apply if its 
application would result in the recognition of a net loss. For this 
purpose, net loss is the excess of aggregate losses over aggregate gains 
(including items of income), without regard to character.
    (2) Basis adjustment. If a corporation recognizes a net gain under 
paragraph (c)(1) of this section, then the converted property has a 
basis in the hands of the RIC or REIT equal to the fair market value of 
such property on the deemed sale date.
    (3) Deemed sale date--(i) RIC or REIT qualifications. If the 
conversion transaction is a qualification of a C corporation as a RIC or 
REIT, then the deemed sale date is the end of the last day of the C 
corporation's last taxable year

[[Page 95]]

before the first taxable year in which it qualifies to be taxed as a RIC 
or REIT.
    (ii) Other conversion transactions. If the conversion transaction is 
a transfer of property owned by a C corporation to a RIC or REIT, then 
the deemed sale date is the end of the day before the day of the 
transfer.
    (4) Anti-stuffing rule. A C corporation must disregard converted 
property in computing gain or loss recognized on the conversion 
transaction under this paragraph (c), if--
    (i) The converted property was acquired by the C corporation in a 
transaction to which section 351 applied or as a contribution to 
capital;
    (ii) Such converted property had an adjusted basis immediately after 
its acquisition by the C corporation in excess of its fair market value 
on the date of acquisition; and
    (iii) The acquisition of such converted property by the C 
corporation was part of a plan a principal purpose of which was to 
reduce gain recognized by the C corporation in connection with the 
conversion transaction. For purposes of this paragraph (c)(4), the 
principles of section 336(d)(2) apply.
    (5) Making the deemed sale election. A C corporation (or a 
partnership to which the principles of this section apply under 
paragraph (e) of this section) makes the deemed sale election with the 
following statement: ``[Insert name and employer identification number 
of electing corporation or partnership] elects deemed sale treatment 
under Sec. 1.337(d)-7(c) with respect to its property that was 
converted to property of, or transferred to, a RIC or REIT, [insert name 
and employer identification number of the RIC or REIT, if different from 
the name and employer identification number of the C corporation or 
partnership].'' This statement must be attached to the Federal income 
tax return of the C corporation or partnership for the taxable year in 
which the deemed sale occurs. An election under this paragraph (c) is 
irrevocable.
    (6) Examples. The rules of this paragraph (c) are illustrated by the 
following examples:

    Example 1. Deemed sale treatment on merger into RIC. (i) X, a 
calendar-year taxpayer, has qualified as a RIC since January 1, 2001. On 
May 31, 2004, Y, a C corporation and calendar-year taxpayer, transfers 
all of its property to X in a transaction that qualifies as a 
reorganization under section 368(a)(1)(C). As a result of the transfer, 
Y would be subject to section 1374 treatment under paragraph (b) of this 
section but for its timely election of deemed sale treatment under this 
paragraph (c). As a result of such election, Y is subject to deemed sale 
treatment on its tax return for the short taxable year ending May 31, 
2004. On May 31, 2004, Y's only assets are Capital Asset, which has a 
fair market value of $100,000 and a basis of $40,000 as of the end of 
May 30, 2004, and $50,000 cash. Y also has an unrestricted net operating 
loss carryforward of $12,000 and accumulated earnings and profits of 
$50,000. Y has no taxable income for the short taxable year ending May 
31, 2004, other than gain recognized under this paragraph (c). In 2007, 
X sells Capital Asset for $110,000. Assume the applicable corporate tax 
rate is 35%.
    (ii) Under this paragraph (c), Y is treated as if it sold the 
converted property (Capital Asset and $50,000 cash) at fair market value 
on May 30, 2004, recognizing $60,000 of gain ($150,000 amount realized--
$90,000 basis). Y must report the gain on its tax return for the short 
taxable year ending May 31, 2004. Y may offset this gain with its 
$12,000 net operating loss carryforward and will pay tax of $16,800 (35% 
of $48,000).
    (iii) Under section 381, X succeeds to Y's accumulated earnings and 
profits. Y's accumulated earnings and profits of $50,000 increase by 
$60,000 and decrease by $16,800 as a result of the deemed sale. Thus, 
the aggregate amount of subchapter C earnings and profits that must be 
distributed to satisfy section 852(a)(2)(B) is $93,200 ($50,000 + 
$60,000-$16,800). X's basis in Capital Asset is $100,000. On X's sale of 
Capital Asset in 2007, X recognizes $10,000 of gain which is taken into 
account in computing X's net capital gain for purposes of section 
852(b)(3).
    Example 2. Loss limitation. (i) Assume the facts are the same as 
those described in Example 1, but that, prior to the reorganization, a 
shareholder of Y contributed to Y a capital asset, Capital Asset 2, 
which has a fair market value of $10,000 and a basis of $20,000, in a 
section 351 transaction.
    (ii) Assuming that Y's acquisition of Capital Asset 2 was made 
pursuant to a plan a principal purpose of which was to reduce the amount 
of gain that Y would recognize in connection with the conversion 
transaction, Capital Asset 2 would be disregarded in computing the 
amount of Y's net gain on the conversion transaction.

    (d) Exceptions--(1) Gain otherwise recognized. Paragraph (a) of this 
section does not apply to any conversion transaction to the extent that 
gain or loss

[[Page 96]]

otherwise is recognized on such conversion transaction. See, for 
example, sections 336, 351(b), 351(e), 356, 357(c), 367, 368(a)(2)(F), 
and 1001.
    (2) Re-election of RIC or REIT status--(i) Generally. Except as 
provided in paragraphs (d)(2)(ii) and (iii) of this section, paragraph 
(a)(1) of this section does not apply to any corporation that--
    (A) Immediately prior to qualifying to be taxed as a RIC or REIT was 
subject to tax as a C corporation for a period not exceeding two taxable 
years; and
    (B) Immediately prior to being subject to tax as a C corporation was 
subject to tax as a RIC or REIT for a period of at least one taxable 
year.
    (ii) Property acquired from another corporation while a C 
corporation. The exception described in paragraph (d)(2)(i) of this 
section does not apply to property acquired by the corporation while it 
was subject to tax as a C corporation from any person in a transaction 
that results in the acquirer's basis in the property being determined by 
reference to a C corporation's basis in the property.
    (iii) RICs and REITs previously subject to section 1374 treatment. 
If the RIC or REIT had property subject to paragraph (b) of this section 
before the RIC or REIT became subject to tax as a C corporation as 
described in paragraph (d)(2)(i) of this section, then paragraph (b) of 
this section applies to the RIC or REIT upon its requalification as a 
RIC or REIT, except that the 10-year recognition period with respect to 
such property is reduced by the portion of the 10-year recognition 
period that expired before the RIC or REIT became subject to tax as a C 
corporation and by the period of time that the corporation was subject 
to tax as a C corporation.
    (e) Special rule for partnerships. The principles of this section 
apply to property transferred by a partnership to a RIC or REIT to the 
extent of any C corporation partner's distributive share of the gain or 
loss in the transferred property. If the partnership were to elect 
deemed sale treatment under paragraph (c) of this section in lieu of 
section 1374 treatment under paragraph (b) of this section with respect 
to such transfer, then any net gain recognized by the partnership on the 
deemed sale must be allocated to the C corporation partner, but does not 
increase the capital account of any partner. Any adjustment to the 
partnership's basis in the RIC or REIT stock as a result of deemed sale 
treatment under paragraph (c) of this section shall constitute an 
adjustment to the basis of that stock with respect to the C corporation 
partner only. The principles of section 743 apply to such basis 
adjustment.
    (f) Effective date. This section applies to conversion transactions 
that occur on or after January 2, 2002. For conversion transactions that 
occurred on or after June 10, 1987, and before January 2, 2002, see 
Sec. Sec. 1.337(d)-5 and 1.337(d)-6.

[T.D. 9047, 68 FR 12822, Mar. 18, 2003]



Sec. 1.338-0  Outline of topics.

    This section lists the captions contained in the regulations under 
section 338 as follows:

 Sec. 1.338-1 General principles; status of old target and new target.

    (a) In general.
    (1) Deemed transaction.
    (2) Application of other rules of law.
    (3) Overview.
    (b) Treatment of target under other provisions of the Internal 
Revenue Code.
    (1) General rule for subtitle A.
    (2) Exceptions for subtitle A.
    (3) General rule for other provisions of the Internal Revenue Code.
    (c) Anti-abuse rule.
    (1) In general.
    (2) Examples.
    (d) Next day rule for post-closing transactions.

Sec. 1.338-2 Nomenclature and definitions; mechanics of the section 338 
                                election.

    (a) Scope.
    (b) Nomenclature.
    (c) Definitions.
    (1) Acquisition date.
    (2) Acquisition date assets.
    (3) Affiliated group.
    (4) Common parent.
    (5) Consistency period.
    (6) Deemed asset sale.
    (7) Deemed sale tax consequences.
    (8) Deemed sale return.
    (9) Domestic corporation.
    (10) Old target's final return.
    (11) Purchasing corporation.
    (12) Qualified stock purchase.

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    (13) Related persons.
    (14) Section 338 election.
    (15) Section 338(h)(10) election.
    (16) Selling group.
    (17) Target; old target; new target.
    (18) Target affiliate.
    (19) 12-month acquisition period.
    (d) Time and manner of making election.
    (e) Special rules for foreign corporations or DISCs.
    (1) Elections by certain foreign purchasing corporations.
    (i) General rule.
    (ii) Qualifying foreign purchasing corporation.
    (iii) Qualifying foreign target.
    (iv) Triggering event.
    (v) Subject to United States tax.
    (2) Acquisition period.
    (3) Statement of section 338 may be filed by United States 
shareholders in certain cases.
    (4) Notice requirement for U.S. persons holding stock in foreign 
target.
    (i) General rule.
    (ii) Limitation.
    (iii) Form of notice.
    (iv) Timing of notice.
    (v) Consequence of failure to comply.
    (vi) Good faith effort to comply.

        Sec. 1.338-3 Qualification for the section 338 election.

    (a) Scope.
    (b) Rules relating to qualified stock purchases.
    (1) Purchasing corporation requirement.
    (2) Purchase.
    (3) Acquisitions of stock from related corporations.
    (i) In general.
    (ii) Time for testing relationship.
    (iii) Cases where section 338(h)(3)(C) applies--acquisitions treated 
as purchases.
    (iv) Examples.
    (4) Acquisition date for tiered targets.
    (i) Stock sold in deemed asset sale.
    (ii) Examples.
    (5) Effect of redemptions.
    (i) General rule.
    (ii) Redemptions from persons unrelated to the purchasing 
corporation.
    (iii) Redemptions from the purchasing corporation or related persons 
during 12-month acquisition period.
    (A) General rule.
    (B) Exception for certain redemptions from related corporations.
    (iv) Examples.
    (c) Effect of post-acquisition events on eligibility for section 338 
election.
    (1) Post-acquisition elimination of target.
    (2) Post-acquisition elimination of the purchasing corporation.
    (d) Consequences of post-acquisition elimination of target where 
section 338 election not made.
    (1) Scope.
    (2) Continuity of interest.
    (3) Control requirement.
    (4) Solely for voting stock requirement.
    (5) Example.

 Sec. 1.338-4 Aggregate deemed sale price; various aspects of taxation 
                        of the deemed asset sale.

    (a) Scope.
    (b) Determination of ADSP.
    (1) General rule.
    (2) Time and amount of ADSP.
    (i) Original determination.
    (ii) Redetermination of ADSP.
    (iii) Example.
    (c) Grossed-up amount realized on the sale to the purchasing 
corporation of the purchasing corporation's recently purchased target 
stock.
    (1) Determination of amount.
    (2) Example.
    (d) Liabilities of old target.
    (1) In general.
    (2) Time and amount of liabilities.
    (e) Deemed sale tax consequences.
    (f) Other rules apply in determining ADSP.
    (g) Examples.
    (h) Deemed sale of target affiliate stock.
    (1) Scope.
    (2) In general.
    (3) Deemed sale of foreign target affiliate by a domestic target.
    (4) Deemed sale producing effectively connected income.
    (5) Deemed sale of insurance company target affiliate electing under 
section 953(d).
    (6) Deemed sale of DISC target affiliate.
    (7) Anti-stuffing rule.
    (8) Examples.

                Sec. 1.338-5 Adjusted grossed-up basis.

    (a) Scope.
    (b) Determination of AGUB.
    (1) General rule.
    (2) Time and amount of AGUB.
    (i) Original determination.
    (ii) Redetermination of AGUB.
    (iii) Examples.
    (c) Grossed-up basis of recently purchased stock.
    (d) Basis of nonrecently purchased stock; gain recognition election.
    (1) No gain recognition election.
    (2) Procedure for making gain recognition election.
    (3) Effect of gain recognition election.
    (i) In general.
    (ii) Basis amount.
    (iii) Losses not recognized.
    (iv) Stock subject to election.
    (e) Liabilities of new target.
    (1) In general.
    (2) Time and amount of liabilities.
    (3) Interaction with deemed sale tax consequences.
    (f) Adjustments by the Internal Revenue Service.

[[Page 98]]

    (g) Examples.

     Sec. 1.338-6 Allocation of ADSP and AGUB among target assets.

    (a) Scope.
    (1) In general.
    (2) Fair market value.
    (i) In general.
    (ii) Transaction costs.
    (iii) Internal Revenue Service authority.
    (b) General rule for allocating ADSP and AGUB.
    (1) Reduction in the amount of consideration for Class I assets.
    (2) Other assets.
    (i) In general.
    (ii) Class II assets.
    (iii) Class III assets.
    (iv) Class IV assets.
    (v) Class V assets.
    (vi) Class VI assets.
    (vii) Class VII assets.
    (3) Other items designated by the Internal Revenue Service.
    (c) Certain limitations and other rules for allocation to an asset.
    (1) Allocation not to exceed fair market value.
    (2) Allocation subject to other rules.
    (3) Special rule for allocating AGUB when purchasing corporation has 
nonrecently purchased stock.
    (i) Scope.
    (ii) Determination of hypothetical purchase price.
    (iii) Allocation of AGUB.
    (4) Liabilities taken into account in determining amount realized on 
subsequent disposition.
    (5) Allocation to certain nuclear decommissioning funds.
    (d) Examples.

  Sec. 1.338-7 Allocation of redetermined ADSP and AGUB among target 
                                 assets.

    (a) Scope.
    (b) Allocation of redetermined ADSP and AGUB.
    (c) Special rules for ADSP.
    (1) Increases or decreases in deemed sale tax consequences taxable 
notwithstanding old target ceases to exist.
    (2) Procedure for transactions in which section 338(h)(10) is not 
elected.
    (i) Deemed sale tax consequences included in new target's return.
    (ii) Carryovers and carrybacks.
    (A) Loss carryovers to new target taxable years.
    (B) Loss carrybacks to taxable years of old target.
    (C) Credit carryovers and carrybacks.
    (3) Procedure for transactions in which section 338(h)(10) is 
elected.
    (d) Special rules for AGUB.
    (1) Effect of disposition or depreciation of acquisition date 
assets.
    (2) Section 38 property.
    (e) Examples.

               Sec. 1.338-8 Asset and stock consistency.

    (a) Introduction.
    (1) Overview.
    (2) General application.
    (3) Extension of the general rules.
    (4) Application where certain dividends are paid.
    (5) Application to foreign target affiliates.
    (6) Stock consistency.
    (b) Consistency for direct acquisitions.
    (1) General rule.
    (2) Section 338(h)(10) elections.
    (c) Gain from disposition reflected in basis of target stock.
    (1) General rule.
    (2) Gain not reflected if section 338 election made for target.
    (3) Gain reflected by reason of distributions.
    (4) Controlled foreign corporations.
    (5) Gain recognized outside the consolidated group.
    (d) Basis of acquired assets.
    (1) Carryover basis rule.
    (2) Exceptions to carryover basis rule for certain assets.
    (3) Exception to carryover basis rule for de minimis assets.
    (4) Mitigation rule.
    (i) General rule.
    (ii) Time for transfer.
    (e) Examples.
    (1) In general.
    (2) Direct acquisitions.
    (f) Extension of consistency to indirect acquisitions.
    (1) Introduction.
    (2) General rule.
    (3) Basis of acquired assets.
    (4) Examples.
    (g) Extension of consistency if dividends qualifying for 100 percent 
dividends received deduction are paid.
    (1) General rule for direct acquisitions from target.
    (2) Other direct acquisitions having same effect.
    (3) Indirect acquisitions.
    (4) Examples.
    (h) Consistency for target affiliates that are controlled foreign 
corporations.
    (1) In general.
    (2) Income or gain resulting from asset dispositions.
    (i) General rule.
    (ii) Basis of controlled foreign corporation stock.
    (iii) Operating rule.
    (iv) Increase in asset or stock basis.
    (3) Stock issued by target affiliate that is a controlled foreign 
corporation.
    (4) Certain distributions.
    (i) General rule.

[[Page 99]]

    (ii) Basis of controlled foreign corporation stock.
    (iii) Increase in asset or stock basis.
    (5) Examples.
    (i) [Reserved]
    (j) Anti-avoidance rules.
    (1) Extension of consistency period.
    (2) Qualified stock purchase and 12-month acquisition period.
    (3) Acquisitions by conduits.
    (i) Asset ownership.
    (A) General rule.
    (B) Application of carryover basis rule.
    (ii) Stock acquisitions.
    (A) Purchase by conduit.
    (B) Purchase of conduit by corporation.
    (C) Purchase of conduit by conduit.
    (4) Conduit.
    (5) Existence of arrangement.
    (6) Predecessor and successor.
    (i) Persons.
    (ii) Assets.
    (7) Examples.

           Sec. 1.338-9 International aspects of section 338.

    (a) Scope.
    (b) Application of section 338 to foreign targets.
    (1) In general.
    (2) Ownership of FT stock on the acquisition date.
    (3) Carryover FT stock.
    (i) Definition.
    (ii) Carryover of earnings and profits.
    (iii) Cap on carryover of earnings and profits.
    (iv) Post-acquisition date distribution of old FT earnings and 
profits.
    (v) Old FT earnings and profits unaffected by post-acquisition date 
deficits.
    (vi) Character of FT stock as carryover FT stock eliminated upon 
disposition.
    (4) Passive foreign investment company stock.
    (c) Dividend treatment under section 1248(e).
    (d) Allocation of foreign taxes.
    (e) Operation of section 338(h)(16). [Reserved]
    (f) Examples.

                    Sec. 1.338-10 Filing of returns.

    (a) Returns including tax liability from deemed asset sale.
    (1) In general.
    (2) Old target's final taxable year otherwise included in 
consolidated return of selling group.
    (i) General rule.
    (ii) Separate taxable year.
    (iii) Carryover and carryback of tax attributes.
    (iv) Old target is a component member of purchasing corporation's 
controlled group.
    (3) Old target is an S corporation.
    (4) Combined deemed sale return.
    (i) General rule.
    (ii) Gain and loss offsets.
    (iii) Procedure for filing a combined return.
    (iv) Consequences of filing a combined return.
    (5) Deemed sale excluded from purchasing corporation's consolidated 
return.
    (6) Due date for old target's final return.
    (i) General rule.
    (ii) Application of Sec. 1.1502-76(c).
    (A) In general.
    (B) Deemed extension.
    (C) Erroneous filing of deemed sale return.
    (D) Erroneous filing of return for regular tax year.
    (E) Last date for payment of tax.
    (7) Examples.
    (b) Waiver.
    (1) Certain additions to tax.
    (2) Notification.
    (3) Elections or other actions required to be specified on a timely 
filed return.
    (i) In general.
    (ii) New target in purchasing corporation's consolidated return.
    (4) Examples.
    (c) Effective/applicability date.

   Sec. 1.338-11 Effect of section 338 election on insurance company 
                                targets.

    (a) In general.
    (b) Computation of ADSP and AGUB.
    (1) Reserves taken into account as a liability.
    (2) Allocation of ADSP and AGUB to specific insurance contracts.
    (c) Application of assumption reinsurance principles.
    (1) In general.
    (2) Reinsurance premium.
    (3) Ceding commission.
    (4) Examples.
    (d) Reserve increases by new target after the deemed asset sale.
    (1) In general.
    (2) Exceptions.
    (3) Amount of additional premium.
    (i) In general.
    (ii) Increases in unpaid loss reserves.
    (iii) Increases in other reserves.
    (4) Limitation on additional premium.
    (5) Treatment of additional premium under section 848.
    (6) Examples.
    (7) Effective/applicability date.
    (i) In general.
    (ii) Application to pre-effective date increases to reserves.
    (e) Effect of section 338 election on section 846(e) election.
    (1) In general.
    (2) Revocation of existing section 846(e) election.
    (f) Effect of section 338 election on old target's capitalization 
amounts under section 848.

[[Page 100]]

    (1) Determination of net consideration for specified insurance 
contracts.
    (2) Determination of capitalization amount.
    (3) Section 381 transactions.
    (g) Effect of section 338 election on policyholders surplus account.
    (h) Effect of section 338 election on section 847 special estimated 
tax payments.

  Sec. 1.338-11T Effect of section 338 election on insurance company 
                          targets (temporary).

    (a) through (c) [Reserved]
    (d) Reserve increases by new target after the deemed asset sale.
    (1) In general.
    (2) Exceptions.
    (3) Amount of additional premium.
    (i) In general.
    (ii) Increases in unpaid loss reserves.
    (iii) Increases in other reserves.
    (4) Limitation on additional premium.
    (5) Treatment of additional premium under section 848.
    (6) Examples.
    (7) Effective dates.
    (i) In general.
    (ii) Application to pre-effective date increases to reserves.
    (e) Effect of section 338 election on section 846(e) election.
    (1) In general.
    (2) Revocation of existing section 846(e) election.
    (f) through (h) [Reserved]

         Sec. 1.338(h)(10)-1 Deemed asset sale and liquidation.

    (a) Scope.
    (b) Definitions.
    (1) Consolidated target.
    (2) Selling consolidated group.
    (3) Selling affiliate; affiliated target.
    (4) S corporation target.
    (5) S corporation shareholders.
    (6) Liquidation.
    (c) Section 338(h)(10) election.
    (1) In general.
    (2) Simultaneous joint election requirement.
    (3) Irrevocability.
    (4) Effect of invalid election.
    (d) Certain consequences of section 338(h)(10) election.
    (1) P.
    (2) New T.
    (3) Old T--deemed sale.
    (i) In general.
    (ii) Tiered targets.
    (4) Old T and selling consolidated group, selling affiliate, or S 
corporation shareholders--deemed liquidation; tax characterization.
    (i) In general.
    (ii) Tiered targets.
    (5) Selling consolidated group, selling affiliate, or S corporation 
shareholders.
    (i) In general.
    (ii) Basis and holding period of T stock not acquired.
    (iii) T stock sale.
    (6) Nonselling minority shareholders other than nonselling S 
corporation shareholders.
    (i) In general.
    (ii) T stock sale.
    (iii) T stock not acquired.
    (7) Consolidated return of selling consolidated group.
    (8) Availability of the section 453 installment method.
    (i) In deemed asset sale.
    (ii) In deemed liquidation.
    (9) Treatment consistent with an actual asset sale.
    (e) Examples.
    (f) Inapplicability of provisions.
    (g) Required information.

              Sec. 1.338(i)-1 Effective dates.

    (a) In general.
    (b) Section 338(h)(10) elections for S corporation targets.
    (c) Section 338 elections for insurance company targets.
    (1) In general.
    (2) New target election for retroactive election.
    (i) Availability of election.
    (ii) Time and manner of making the election for new target.
    (3) Old target election for retroactive election.
    (i) Availability of election.
    (ii) Time and manner of making the election for old target.

[T.D. 8940, 66 FR 9929, Feb. 13, 2001, as amended by T.D. 9158, 70 FR 
55741, Sept. 16, 2004; T.D. 9257, 71 FR 17999, Apr. 10, 2006; T.D. 9264, 
71 FR 30595, May 30, 2006; T.D. 9358, 72 FR 51705, Sept. 11, 2007; T.D. 
9377, 73 FR 3871, Jan. 23, 2008]



Sec. 1.338-1  General principles; status of old target and new target.

    (a) In general--(1) Deemed transaction. Elections are available 
under section 338 when a purchasing corporation acquires the stock of 
another corporation (the target) in a qualified stock purchase. One type 
of election, under section 338(g), is available to the purchasing 
corporation. Another type of election, under section 338(h)(10), is, in 
more limited circumstances, available jointly to the purchasing 
corporation and the sellers of the stock. (Rules concerning eligibility 
for these elections are contained in Sec. Sec. 1.338-2, 1.338-3, and 
1.338(h)(10)-1.) Although target is a single corporation under corporate 
law, if a section 338 election is made, then two

[[Page 101]]

separate corporations, old target and new target, generally are 
considered to exist for purposes of subtitle A of the Internal Revenue 
Code. Old target is treated as transferring all of its assets to an 
unrelated person in exchange for consideration that includes the 
discharge of its liabilities (see Sec. 1.1001-2(a)), and new target is 
treated as acquiring all of its assets from an unrelated person in 
exchange for consideration that includes the assumption of those 
liabilities. (Such transaction is, without regard to its 
characterization for Federal income tax purposes, referred to as the 
deemed asset sale and the income tax consequences thereof as the deemed 
sale tax consequences.) If a section 338(h)(10) election is made, old 
target is deemed to liquidate following the deemed asset sale.
    (2) Application of other rules of law. Other rules of law apply to 
determine the tax consequences to the parties as if they had actually 
engaged in the transactions deemed to occur under section 338 and the 
regulations thereunder except to the extent otherwise provided in those 
regulations. See also Sec. 1.338-6(c)(2). Other rules of law may 
characterize the transaction as something other than or in addition to a 
sale and purchase of assets; however, the transaction between old and 
new target must be a taxable transaction. For example, if the target is 
an insurance company for which a section 338 election is made, the 
deemed asset sale results in an assumption reinsurance transaction for 
the insurance contracts deemed transferred from old target to new 
target. See, generally, Sec. 1.817-4(d), and for special rules 
regarding the acquisition of insurance company targets, Sec. 1.338-11. 
See also Sec. 1.367(a)-8(k)(13) for a rule applicable to gain 
recognition agreements (filed under Sec. Sec. 1.367(a)-3(b)(1)(ii) and 
1.367(a)-8) and deemed asset sales as a result of an election under 
section 338(g).
    (3) Overview. Definitions and special nomenclature and rules for 
making the section 338 election are provided in Sec. 1.338-2. 
Qualification for the section 338 election is addressed in Sec. 1.338-
3. The amount for which old target is treated as selling all of its 
assets (the aggregate deemed sale price, or ADSP) is addressed in Sec. 
1.338-4. The amount for which new target is deemed to have purchased all 
its assets (the adjusted grossed-up basis, or AGUB) is addressed in 
Sec. 1.338-5. Section 1.338-6 addresses allocation both of ADSP among 
the assets old target is deemed to have sold and of AGUB among the 
assets new target is deemed to have purchased. Section 1.338-7 addresses 
allocation of ADSP or AGUB when those amounts subsequently change. Asset 
and stock consistency are addressed in Sec. 1.338-8. International 
aspects of section 338 are covered in Sec. 1.338-9. Rules for the 
filing of returns are provided in Sec. 1.338-10. Section 1.338-11 
provides special rules for insurance company targets. Eligibility for 
and treatment of section 338(h)(10) elections is addressed in Sec. 
1.338(h)(10)-1.
    (b) Treatment of target under other provisions of the Internal 
Revenue Code--(1) General rule for subtitle A. Except as provided in 
this section, new target is treated as a new corporation that is 
unrelated to old target for purposes of subtitle A of the Internal 
Revenue Code. Thus--
    (i) New target is not considered related to old target for purposes 
of section 168 and may make new elections under section 168 without 
taking into account the elections made by old target; and
    (ii) New target may adopt, without obtaining prior approval from the 
Commissioner, any taxable year that meets the requirements of section 
441 and any method of accounting that meets the requirements of section 
446. Notwithstanding Sec. 1.441-1T(b)(2), a new target may adopt a 
taxable year on or before the last day for making the election under 
section 338 by filing its first return for the desired taxable year on 
or before that date.
    (2) Exceptions for subtitle A. New target and old target are treated 
as the same corporation for purposes of--
    (i) The rules applicable to employee benefit plans (including those 
plans described in sections 79, 104, 105, 106, 125, 127, 129, 132, 137, 
and 220), qualified pension, profit-sharing, stock bonus and annuity 
plans (sections 401(a) and 403(a)), simplified employee pensions 
(section 408(k)), tax qualified stock option plans (sections 422 and 
423), welfare benefit funds (sections 419, 419A,

[[Page 102]]

512(a)(3), and 4976), and voluntary employee benefit associations 
(section 501(c)(9) and the regulations thereunder);
    (ii) Sections 1311 through 1314 (relating to the mitigation of the 
effect of limitations), if a section 338(h)(10) election is not made for 
target;
    (iii) Section 108(e)(5) (relating to the reduction of purchase money 
debt);
    (iv) Section 45A (relating to the Indian Employment Credit), section 
51 (relating to the Work Opportunity Credit), section 51A (relating to 
the Welfare to Work Credit), and section 1396 (relating to the 
Empowerment Zone Act);
    (v) Sections 401(h) and 420 (relating to medical benefits for 
retirees);
    (vi) Section 414 (relating to definitions and special rules); and
    (vii) Section 846(e) (relating to an election to use an insurance 
company's historical loss payment pattern).
    (viii) Any other provision designated in the Internal Revenue 
Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of 
this chapter. See, for example, Sec. 1.1001-3(e)(4)(i)(F) providing 
that an election under section 338 does not result in the substitution 
of a new obligor on target's debt. See also, for example, Sec. 1.1502-
77(e)(4), providing that an election under section 338 does not result 
in a deemed termination of target's existence for purposes of the rules 
applicable to the agent for a consolidated group.
    (3) General rule for other provisions of the Internal Revenue Code. 
Except as provided in the regulations under section 338 or in the 
Internal Revenue Bulletin by the Internal Revenue Service (see Sec. 
601.601(d)(2)(ii) of this chapter), new target is treated as a 
continuation of old target for purposes other than subtitle A of the 
Internal Revenue Code. For example--
    (i) New target is liable for old target's Federal income tax 
liabilities, including the tax liability for the deemed sale tax 
consequences and those tax liabilities of the other members of any 
consolidated group that included old target that are attributable to 
taxable years in which those corporations and old target joined in the 
same consolidated return (see Sec. 1.1502-6(a));
    (ii) Wages earned by the employees of old target are considered 
wages earned by such employees from new target for purposes of sections 
3101 and 3111 (Federal Insurance Contributions Act) and section 3301 
(Federal Unemployment Tax Act); and
    (iii) Old target and new target must use the same employer 
identification number.
    (c) Anti-abuse rule--(1) In general. The rules of this paragraph (c) 
apply for purposes of applying the residual method as provided for under 
the regulations under sections 338 and 1060. The Commissioner is 
authorized to treat any property (including cash) transferred by old 
target in connection with the transactions resulting in the application 
of the residual method (and not held by target at the close of the 
acquisition date) as, nonetheless, property of target at the close of 
the acquisition date if the property so transferred is, within 24 months 
after the deemed asset sale, owned by new target, or is owned, directly 
or indirectly, by a member of the affiliated group of which new target 
is a member and continues after the acquisition date to be held or used 
primarily in connection with one or more of the activities of new 
target. In addition, the Commissioner is authorized to treat any 
property (including cash) transferred to old target in connection with 
the transactions resulting in the application of the residual method 
(and held by target at the close of the acquisition date) as, 
nonetheless, not being property of target at the close of the 
acquisition date if the property so transferred is, within 24 months 
after the deemed asset sale, not owned by new target but owned, directly 
or indirectly, by a member of the affiliated group of which new target 
is a member, or owned by new target but held or used primarily in 
connection with an activity conducted, directly or indirectly, by 
another member of the affiliated group of which new target is a member 
in combination with other property retained by or acquired, directly or 
indirectly, from the transferor of the property (or a member of the same 
affiliated group) to old target. For purposes of this paragraph (c)(1), 
an interest in an entity is considered held or used in

[[Page 103]]

connection with an activity if property of the entity is so held or 
used. The authority of the Commissioner under this paragraph (c)(1) 
includes the making of any appropriate correlative adjustments 
(avoiding, to the extent possible, the duplication or omission of any 
item of income, gain, loss, deduction, or basis).
    (2) Examples. The following examples illustrate this paragraph (c):

    Example 1. Prior to a qualified stock purchase under section 338, 
target transfers one of its assets to a related party. The purchasing 
corporation then purchases the target stock and also purchases the 
transferred asset from the related party. After its purchase of target, 
the purchasing corporation and target are members of the same affiliated 
group. A section 338 election is made. Under an arrangement with the 
purchaser, the separately transferred asset is used primarily in 
connection with target's activities. Applying the anti-abuse rule of 
this paragraph (c), the Commissioner may consider target to own the 
transferred asset for purposes of applying the residual method under 
section 338.
    Example 2. T owns all the stock of T1. T1 leases intellectual 
property to T, which T uses in connection with its own activities. P, a 
purchasing corporation, wishes to buy the T-T1 chain of corporations. P, 
in connection with its planned purchase of the T stock, contracts to 
consummate a purchase of all the stock of T1 on March 1 and of all the 
stock of T on March 2. Section 338 elections are thereafter made for 
both T and T1. Immediately after the purchases, P, T and T1 are members 
of the same affiliated group. T continues to lease the intellectual 
property from T1 and that is the primary use of the intellectual 
property. Thus, an asset of T, the T1 stock, was removed from T's own 
assets prior to the qualified stock purchase of the T stock, T1's own 
assets are used after the deemed asset sale in connection with T's own 
activities, and the T1 stock is after the deemed asset sale owned by P, 
a member of the same affiliated group of which T is a member. Applying 
the anti-abuse rule of this paragraph (c), the Commissioner may, for 
purposes of application of the residual method under section 338 both to 
T and to T1, consider P to have bought only the stock of T, with T at 
the time of the qualified stock purchases of both T and T1 (the 
qualified stock purchase of T1 being triggered by the deemed sale under 
section 338 of T's assets) owning T1. The Commissioner accordingly would 
allocate consideration to T's assets as though the T1 stock were one of 
those assets, and then allocate consideration within T1 based on the 
amount allocated to the T1 stock at the T level.

    (d) Next day rule for post-closing transactions. If a target 
corporation for which an election under section 338 is made engages in a 
transaction outside the ordinary course of business on the acquisition 
date after the event resulting in the qualified stock purchase of the 
target or a higher tier corporation, the target and all persons related 
thereto (either before or after the qualified stock purchase) under 
section 267(b) or section 707 must treat the transaction for all Federal 
income tax purposes as occurring at the beginning of the day following 
the transaction and after the deemed purchase by new target.

[T.D. 8940, 66 FR 9929, Feb. 13, 2001, as amended by T.D. 9002, 67 FR 
43540, June 28, 2002; T.D. 9257, 71 FR 18000, Apr. 10, 2006; T.D. 9377, 
73 FR 3871, Jan. 23, 2008; T.D. 9446, 74 FR 6957, Feb. 11, 2009]



Sec. 1.338-2  Nomenclature and definitions; mechanics of the section 338 election.

    (a) Scope. This section prescribes rules relating to elections under 
section 338.
    (b) Nomenclature. For purposes of the regulations under section 338 
(except as otherwise provided):
    (1) T is a domestic target corporation that has only one class of 
stock outstanding. Old T refers to T for periods ending on or before the 
close of T's acquisition date; new T refers to T for subsequent periods.
    (2) P is the purchasing corporation.
    (3) The P group is an affiliated group of which P is a member.
    (4) P1, P2, etc., are domestic corporations that are members of the 
P group.
    (5) T1, T2, etc., are domestic corporations that are target 
affiliates of T. These corporations (T1, T2, etc.) have only one class 
of stock outstanding and may also be targets.
    (6) S is a domestic corporation (unrelated to P and B) that owns T 
prior to the purchase of T by P. (S is referred to in cases in which it 
is appropriate to consider the effects of having all of the outstanding 
stock of T owned by a domestic corporation.)
    (7) A, a U.S. citizen or resident, is an individual (unrelated to P 
and B) who owns T prior to the purchase of T by P. (A is referred to in 
cases in which it is

[[Page 104]]

appropriate to consider the effects of having all of the outstanding 
stock of T owned by an individual who is a U.S. citizen or resident. 
Ownership of T by A and ownership of T by S are mutually exclusive 
circumstances.)
    (8) B, a U.S. citizen or resident, is an individual (unrelated to T, 
S, and A) who owns the stock of P.
    (9) F, used as a prefix with the other terms in this paragraph (b), 
connotes foreign, rather than domestic, status. For example, FT is a 
foreign corporation (as defined in section 7701(a)(5)) and FA is an 
individual other than a U.S. citizen or resident.
    (10) CFC, used as a prefix with the other terms in this paragraph 
(b) referring to a corporation, connotes a controlled foreign 
corporation (as defined in section 957, taking into account section 
953(c)). A corporation identified with the prefix F may be a controlled 
foreign corporation. (The prefix CFC is used when the corporation's 
status as a controlled foreign corporation is significant.)
    (c) Definitions. For purposes of the regulations under section 338 
(except as otherwise provided):
    (1) Acquisition date. The term acquisition date has the same meaning 
as in section 338(h)(2).
    (2) Acquisition date assets. Acquisition date assets are the assets 
of the target held at the beginning of the day after the acquisition 
date (but see Sec. 1.338-1(d) (regarding certain transactions on the 
acquisition date)).
    (3) Affiliated group. The term affiliated group has the same meaning 
as in section 338(h)(5). Corporations are affiliated on any day they are 
members of the same affiliated group.
    (4) Common parent. The term common parent has the same meaning as in 
section 1504.
    (5) Consistency period. The consistency period is the period 
described in section 338(h)(4)(A) unless extended pursuant to Sec. 
1.338-8(j)(1).
    (6) Deemed asset sale. The deemed asset sale is the transaction 
described in Sec. 1.338-1(a)(1) that is deemed to occur for purposes of 
subtitle A of the Internal Revenue Code if a section 338 election is 
made.
    (7) Deemed sale tax consequences. Deemed sale tax consequences 
refers to, in the aggregate, the Federal income tax consequences 
(generally, the income, gain, deduction, and loss) of the deemed asset 
sale. Deemed sale tax consequences also refers to the Federal income tax 
consequences of the transfer of a particular asset in the deemed asset 
sale.
    (8) Deemed sale return. The deemed sale return is the return on 
which target's deemed sale tax consequences are reported that does not 
include any other items of target. Target files a deemed sale return 
when a section 338 election (but not a section 338(h)(10) election) is 
filed for target and target is a member of a selling group (defined in 
paragraph (c)(16) of this section) that files a consolidated return for 
the period that includes the acquisition date. See Sec. 1.338-10. If 
target is an S corporation for the period that ends on the day before 
the acquisition date and a section 338 election (but not a section 
338(h)(10) election) is filed for target, see Sec. 1.338-10(a)(3).
    (9) Domestic corporation. A domestic corporation is a corporation--
    (i) That is domestic within the meaning of section 7701(a)(4) or 
that is treated as domestic for purposes of subtitle A of the Internal 
Revenue Code (e.g., to which an election under section 953(d) or 1504(d) 
applies); and
    (ii) That is not a DISC, a corporation described in section 1248(e), 
or a corporation to which an election under section 936 applies.
    (10) Old target's final return. Old target's final return is the 
income tax return of old target for the taxable year ending at the close 
of the acquisition date that includes the deemed sale tax consequences. 
However, if a deemed sale return is filed for old target, the deemed 
sale return is considered old target's final return.
    (11) Purchasing corporation. The term purchasing corporation has the 
same meaning as in section 338(d)(1). The purchasing corporation may 
also be referred to as purchaser. Unless otherwise provided, any 
reference to the purchasing corporation is a reference to all members of 
the affiliated group of which the purchasing corporation is a member. 
See sections 338(h)(5) and (8). Also, unless otherwise provided, any

[[Page 105]]

reference to the purchasing corporation is, with respect to a deemed 
purchase of stock under section 338(a)(2), a reference to new target 
with respect to its own deemed purchase of stock in another target.
    (12) Qualified stock purchase. The term qualified stock purchase has 
the same meaning as in section 338(d)(3).
    (13) Related persons. Two persons are related if stock in a 
corporation owned by one of the persons would be attributed under 
section 318(a) (other than section 318(a)(4)) to the other.
    (14) Section 338 election. A section 338 election is an election to 
apply section 338(a) to target. A section 338 election is made by filing 
a statement of section 338 election pursuant to paragraph (d) of this 
section. The form on which this statement is filed is referred to in the 
regulations under section 338 as the Form 8023, ``Elections Under 
Section 338 For Corporations Making Qualified Stock Purchases.''
    (15) Section 338(h)(10) election. A section 338(h)(10) election is 
an election to apply section 338(h)(10) to target. A section 338(h)(10) 
election is made by making a joint election for target under Sec. 
1.338(h)(10)-1 on Form 8023.
    (16) Selling group. The selling group is the affiliated group (as 
defined in section 1504) eligible to file a consolidated return that 
includes target for the taxable period in which the acquisition date 
occurs. However, a selling group is not an affiliated group of which 
target is the common parent on the acquisition date.
    (17) Target; old target; new target. Target is the target 
corporation as defined in section 338(d)(2). Old target refers to target 
for periods ending on or before the close of target's acquisition date. 
New target refers to target for subsequent periods.
    (18) Target affiliate. The term target affiliate has the same 
meaning as in section 338(h)(6) (applied without section 
338(h)(6)(B)(i)). Thus, a corporation described in section 
338(h)(6)(B)(i) is considered a target affiliate for all purposes of 
section 338. If a target affiliate is acquired in a qualified stock 
purchase, it is also a target.
    (19) 12-month acquisition period. The 12-month acquisition period is 
the period described in section 338(h)(1), unless extended pursuant to 
Sec. 1.338-8(j)(2).
    (d) Time and manner of making election. The purchasing corporation 
makes a section 338 election for target by filing a statement of section 
338 election on Form 8023 in accordance with the instructions to the 
form. The section 338 election must be made not later than the 15th day 
of the 9th month beginning after the month in which the acquisition date 
occurs. A section 338 election is irrevocable. See Sec. 1.338(h)(10)-
1(c)(2) for section 338(h)(10) elections.
    (e) Special rules for foreign corporations or DISCs--(1) Elections 
by certain foreign purchasing corporations--(i) General rule. A 
qualifying foreign purchasing corporation is not required to file a 
statement of section 338 election for a qualifying foreign target before 
the earlier of 3 years after the acquisition date and the 180th day 
after the close of the purchasing corporation's taxable year within 
which a triggering event occurs.
    (ii) Qualifying foreign purchasing corporation. A purchasing 
corporation is a qualifying foreign purchasing corporation only if, 
during the acquisition period of a qualifying foreign target, all the 
corporations in the purchasing corporation's affiliated group are 
foreign corporations that are not subject to United States tax.
    (iii) Qualifying foreign target. A target is a qualifying foreign 
target only if target and its target affiliates are foreign corporations 
that, during target's acquisition period, are not subject to United 
States tax (and will not become subject to United States tax during such 
period because of a section 338 election). A target affiliate is taken 
into account for purposes of the preceding sentence only if, during 
target's 12-month acquisition period, it is or becomes a member of the 
affiliated group that includes the purchasing corporation.
    (iv) Triggering event. A triggering event occurs in the taxable year 
of the qualifying foreign purchasing corporation in which either that 
corporation or any corporation in its affiliated group becomes subject 
to United States tax.

[[Page 106]]

    (v) Subject to United States tax. For purposes of this paragraph 
(e)(1), a foreign corporation is considered subject to United States 
tax--
    (A) For the taxable year for which that corporation is required 
under Sec. 1.6012-2(g) (other than Sec. 1.6012-2(g)(2)(i)(B)(2)) to 
file a United States income tax return; or
    (B) For the period during which that corporation is a controlled 
foreign corporation, a passive foreign investment company for which an 
election under section 1295 is in effect, a foreign investment company, 
or a foreign corporation the stock ownership of which is described in 
section 552(a)(2).
    (2) Acquisition period. For purposes of this paragraph (e), the term 
acquisition period means the period beginning on the first day of the 
12-month acquisition period and ending on the acquisition date.
    (3) Statement of section 338 election may be filed by United States 
shareholders in certain cases. The United States shareholders (as 
defined in section 951(b)) of a foreign purchasing corporation that is a 
controlled foreign corporation (as defined in section 957 (taking into 
account section 953(c))) may file a statement of section 338 election on 
behalf of the purchasing corporation if the purchasing corporation is 
not required under Sec. 1.6012-2(g) (other than Sec. 1.6012-
2(g)(2)(i)(B)(2)) to file a United States income tax return for its 
taxable year that includes the acquisition date. Form 8023 must be filed 
as described in the form and its instructions and also must be attached 
to the Form 5471, ``Information Returns of U.S. Persons With Respect to 
Certain Foreign Corporations,'' filed with respect to the purchasing 
corporation by each United States shareholder for the purchasing 
corporation's taxable year that includes the acquisition date (or, if 
paragraph (e)(1)(i) of this section applies to the election, for the 
purchasing corporation's taxable year within which it becomes a 
controlled foreign corporation). The provisions of Sec. 1.964-1(c) 
(including Sec. 1.964-1(c)(7)) do not apply to an election made by the 
United States shareholders.
    (4) Notice requirement for U.S. persons holding stock in foreign 
target--(i) General rule. If a target subject to a section 338 election 
was a controlled foreign corporation, a passive foreign investment 
company, or a foreign personal holding company at any time during the 
portion of its taxable year that ends on its acquisition date, the 
purchasing corporation must deliver written notice of the election (and 
a copy of Form 8023, its attachments and instructions) to--
    (A) Each U.S. person (other than a member of the affiliated group of 
which the purchasing corporation is a member (the purchasing group 
member)) that, on the acquisition date of the foreign target, holds 
stock in the foreign target; and
    (B) Each U.S. person (other than a purchasing group member) that 
sells stock in the foreign target to a purchasing group member during 
the foreign target's 12-month acquisition period.
    (ii) Limitation. The notice requirement of this paragraph (e)(4) 
applies only where the section 338 election for the foreign target 
affects income, gain, loss, deduction, or credit of the U.S. person 
described in paragraph (e)(4)(i) of this section under section 551, 951, 
1248, or 1293.
    (iii) Form of notice. The notice to U.S. persons must be identified 
prominently as a notice of section 338 election and must--
    (A) Contain the name, address, and employer identification number 
(if any) of, and the country (and, if relevant, the lesser political 
subdivision) under the laws of which are organized the purchasing 
corporation and the relevant target (i.e., the target the stock of which 
the particular U.S. person held or sold under the circumstances 
described in paragraph (e)(4)(i) of this section);
    (B) Identify those corporations as the purchasing corporation and 
the foreign target, respectively; and
    (C) Contain the following declaration (or a substantially similar 
declaration):

    THIS DOCUMENT SERVES AS NOTICE OF AN ELECTION UNDER SECTION 338 FOR 
THE ABOVE CITED FOREIGN TARGET THE STOCK OF WHICH YOU EITHER HELD OR 
SOLD UNDER THE CIRCUMSTANCES DESCRIBED IN TREASURY REGULATIONS SECTION 
1.338-2(e)(4). FOR

[[Page 107]]

POSSIBLE UNITED STATES FEDERAL INCOME TAX CONSEQUENCES UNDER SECTION 
551, 951, 1248, OR 1293 OF THE INTERNAL REVENUE CODE OF 1986 THAT MAY 
APPLY TO YOU, SEE TREASURY REGULATIONS SECTION 1.338-9(b). YOU MAY BE 
REQUIRED TO ATTACH THE INFORMATION ATTACHED TO THIS NOTICE TO CERTAIN 
RETURNS.

    (iv) Timing of notice. The notice required by this paragraph (e)(4) 
must be delivered to the U.S. person on or before the later of the 120th 
day after the acquisition date of the particular target or the day on 
which Form 8023 is filed. The notice is considered delivered on the date 
it is mailed to the proper address (or an address similar enough to 
complete delivery), unless the date it is mailed cannot be reasonably 
determined. The date of mailing will be determined under the rules of 
section 7502. For example, the date of mailing is the date of U.S. 
postmark or the applicable date recorded or marked by a designated 
delivery service.
    (v) Consequence of failure to comply. A statement of section 338 
election is not valid if timely notice is not given to one or more U.S. 
persons described in this paragraph (e)(4). If the form of notice fails 
to comply with all requirements of this paragraph (e)(4), the section 
338 election is valid, but the waiver rule of Sec. 1.338-10(b)(1) does 
not apply.
    (vi) Good faith effort to comply. The purchasing corporation will be 
considered to have complied with this paragraph (e)(4), even though it 
failed to provide notice or provide timely notice to each person 
described in this paragraph (e)(4), if the Commissioner determines that 
the purchasing corporation made a good faith effort to identify and 
provide timely notice to those U.S. persons.

[T.D. 8940, 66 FR 9929, Feb. 13, 2001]



Sec. 1.338-3  Qualification for the section 338 election.

    (a) Scope. This section provides rules on whether certain 
acquisitions of stock are qualified stock purchases and on other 
miscellaneous issues under section 338.
    (b) Rules relating to qualified stock purchases--(1) Purchasing 
corporation requirement. An individual cannot make a qualified stock 
purchase of target. Section 338(d)(3) requires, as a condition of a 
qualified stock purchase, that a corporation purchase the stock of 
target. If an individual forms a corporation (new P) to acquire target 
stock, new P can make a qualified stock purchase of target if new P is 
considered for tax purposes to purchase the target stock. Facts that may 
indicate that new P does not purchase the target stock include new P's 
merging downstream into target, liquidating, or otherwise disposing of 
the target stock following the purported qualified stock purchase.
    (2) Purchase. The term purchase has the same meaning as in section 
338(h)(3). Stock in a target (or target affiliate) may be considered 
purchased if, under general principles of tax law, the purchasing 
corporation is considered to own stock of the target (or target 
affiliate) meeting the requirements of section 1504(a)(2), 
notwithstanding that no amount may be paid for (or allocated to) the 
stock.
    (3) Acquisitions of stock from related corporations--(i) In general. 
Stock acquired by a purchasing corporation from a related corporation 
(R) is generally not considered acquired by purchase. See section 
338(h)(3)(A)(iii).
    (ii) Time for testing relationship. For purposes of section 
338(h)(3)(A)(iii), a purchasing corporation is treated as related to 
another person if the relationship specified in section 
338(h)(3)(A)(iii) exists--
    (A) In the case of a single transaction, immediately after the 
purchase of target stock;
    (B) In the case of a series of acquisitions otherwise constituting a 
qualified stock purchase within the meaning of section 338(d)(3), 
immediately after the last acquisition in such series; and
    (C) In the case of a series of transactions effected pursuant to an 
integrated plan to dispose of target stock, immediately after the last 
transaction in such series.
    (iii) Cases where section 338(h)(3)(C) applies--acquisitions treated 
as purchases. If section 338(h)(3)(C) applies and the purchasing 
corporation is treated as acquiring stock by purchase from R, solely for 
purposes of determining when the stock is considered acquired, target 
stock acquired from R is considered to have been acquired by

[[Page 108]]

the purchasing corporation on the day on which the purchasing 
corporation is first considered to own that stock under section 318(a) 
(other than section 318(a)(4)).
    (iv) Examples. The following examples illustrate this paragraph 
(b)(3):

    Example 1. (i) S is the parent of a group of corporations that are 
engaged in various businesses. Prior to January 1, Year 1, S decided to 
discontinue its involvement in one line of business. To accomplish this, 
S forms a new corporation, Newco, with a nominal amount of cash. Shortly 
thereafter, on January 1, Year 1, S transfers all the stock of the 
subsidiary conducting the unwanted business (T) to Newco in exchange for 
100 shares of Newco common stock and a Newco promissory note. Prior to 
January 1, Year 1, S and Underwriter (U) had entered into a binding 
agreement pursuant to which U would purchase 60 shares of Newco common 
stock from S and then sell those shares in an Initial Public Offering 
(IPO). On January 6, Year 1, the IPO closes.
    (ii) Newco's acquisition of T stock is one of a series of 
transactions undertaken pursuant to one integrated plan. The series of 
transactions ends with the closing of the IPO and the transfer of all 
the shares of stock in accordance with the agreements. Immediately after 
the last transaction effected pursuant to the plan, S owns 40 percent of 
Newco, which does not give rise to a relationship described in section 
338(h)(3)(A)(iii). See Sec. 1.338-3(b)(3)(ii)(C). Accordingly, S and 
Newco are not related for purposes of section 338(h)(3)(A)(iii).
    (iii) Further, because Newco's basis in the T stock is not 
determined by reference to S's basis in the T stock and because the 
transaction is not an exchange to which section 351, 354, 355, or 356 
applies, Newco's acquisition of the T stock is a purchase within the 
meaning of section 338(h)(3).
    Example 2. (i) On January 1 of Year 1, P purchases 75 percent in 
value of the R stock. On that date, R owns 4 of the 100 shares of T 
stock. On June 1 of Year 1, R acquires an additional 16 shares of T 
stock. On December 1 of Year 1, P purchases 70 shares of T stock from an 
unrelated person and 12 of the 20 shares of T stock held by R.
    (ii) Of the 12 shares of T stock purchased by P from R on December 1 
of Year 1, 3 of those shares are deemed to have been acquired by P on 
January 1 of Year 1, the date on which 3 of the 4 shares of T stock held 
by R on that date were first considered owned by P under section 
318(a)(2)(C) (i.e., 4 x .75). The remaining 9 shares of T stock 
purchased by P from R on December 1 of Year 1 are deemed to have been 
acquired by P on June 1 of Year 1, the date on which an additional 12 of 
the 20 shares of T stock owned by R on that date were first considered 
owned by P under section 318(a)(2)(C) (i.e., (20 x .75)-3). Because 
stock acquisitions by P sufficient for a qualified stock purchase of T 
occur within a 12-month period (i.e., 3 shares constructively on January 
1 of Year 1, 9 shares constructively on June 1 of Year 1, and 70 shares 
actually on December 1 of Year 1), a qualified stock purchase is made on 
December 1 of Year 1.
    Example 3. (i) On February 1 of Year 1, P acquires 25 percent in 
value of the R stock from B (the sole shareholder of P). That R stock is 
not acquired by purchase. See section 338(h)(3)(A)(iii). On that date, R 
owns 4 of the 100 shares of T stock. On June 1 of Year 1, P purchases an 
additional 25 percent in value of the R stock, and on January 1 of Year 
2, P purchases another 25 percent in value of the R stock. On June 1 of 
Year 2, R acquires an additional 16 shares of the T stock. On December 1 
of Year 2, P purchases 68 shares of the T stock from an unrelated person 
and 12 of the 20 shares of the T stock held by R.
    (ii) Of the 12 shares of the T stock purchased by P from R on 
December 1 of Year 2, 2 of those shares are deemed to have been acquired 
by P on June 1 of Year 1, the date on which 2 of the 4 shares of the T 
stock held by R on that date were first considered owned by P under 
section 318(a)(2)(C) (i.e., 4 x .5). For purposes of this attribution, 
the R stock need not be acquired by P by purchase. See section 
338(h)(1). (By contrast, the acquisition of the T stock by P from R does 
not qualify as a purchase unless P has acquired at least 50 percent in 
value of the R stock by purchase. Section 338(h)(3)(C)(i).) Of the 
remaining 10 shares of the T stock purchased by P from R on December 1 
of Year 2, 1 of those shares is deemed to have been acquired by P on 
January 1 of Year 2, the date on which an additional 1 share of the 4 
shares of the T stock held by R on that date was first considered owned 
by P under section 318(a)(2)(C) (i.e., (4 x .75)-2). The remaining 9 
shares of the T stock purchased by P from R on December 1 of Year 2, are 
deemed to have been acquired by P on June 1 of Year 2, the date on which 
an additional 12 shares of the T stock held by R on that date were first 
considered owned by P under section 318(a)(2)(C) (i.e., (20 x .75)-3). 
Because a qualified stock purchase of T by P is made on December 1 of 
Year 2 only if all 12 shares of the T stock purchased by P from R on 
that date are considered acquired during a 12-month period ending on 
that date (so that, in conjunction with the 68 shares of the T stock P 
purchased on that date from the unrelated person, 80 of T's 100 shares 
are acquired by P during a 12-month period) and because 2 of those 12 
shares are considered to have been acquired by P more than 12 months 
before December 1 of Year 2 (i.e., on June 1 of Year 1), a qualified 
stock purchase is not made.

[[Page 109]]

(Under Sec. 1.338-8(j)(2), for purposes of applying the consistency 
rules, P is treated as making a qualified stock purchase of T if, 
pursuant to an arrangement, P purchases T stock satisfying the 
requirements of section 1504(a)(2) over a period of more than 12 
months.)
    Example 4. Assume the same facts as in Example 3, except that on 
February 1 of Year 1, P acquires 25 percent in value of the R stock by 
purchase. The result is the same as in Example 3.

    (4) Acquisition date for tiered targets--(i) Stock sold in deemed 
asset sale. If an election under section 338 is made for target, old 
target is deemed to sell target's assets and new target is deemed to 
acquire those assets. Under section 338(h)(3)(B), new target's deemed 
purchase of stock of another corporation is a purchase for purposes of 
section 338(d)(3) on the acquisition date of target. If new target's 
deemed purchase causes a qualified stock purchase of the other 
corporation and if a section 338 election is made for the other 
corporation, the acquisition date for the other corporation is the same 
as the acquisition date of target. However, the deemed sale and purchase 
of the other corporation's assets is considered to take place after the 
deemed sale and purchase of target's assets.
    (ii) Example. The following example illustrates this paragraph 
(b)(4):

    Example. A owns all of the T stock. T owns 50 of the 100 shares of X 
stock. The other 50 shares of X stock are owned by corporation Y, which 
is unrelated to A, T, or P. On January 1 of Year 1, P makes a qualified 
stock purchase of T from A and makes a section 338 election for T. On 
December 1 of Year 1, P purchases the 50 shares of X stock held by Y. A 
qualified stock purchase of X is made on December 1 of Year 1, because 
the deemed purchase of 50 shares of X stock by new T because of the 
section 338 election for T and the actual purchase of 50 shares of X 
stock by P are treated as purchases made by one corporation. Section 
338(h)(8). For purposes of determining whether those purchases occur 
within a 12-month acquisition period as required by section 338(d)(3), T 
is deemed to purchase its X stock on T's acquisition date, i.e., January 
1 of Year 1.

    (5) Effect of redemptions--(i) General rule. Except as provided in 
this paragraph (b)(5), a qualified stock purchase is made on the first 
day on which the percentage ownership requirements of section 338(d)(3) 
are satisfied by reference to target stock that is both--
    (A) Held on that day by the purchasing corporation; and
    (B) Purchased by the purchasing corporation during the 12-month 
period ending on that day.
    (ii) Redemptions from persons unrelated to the purchasing 
corporation. Target stock redemptions from persons unrelated to the 
purchasing corporation that occur during the 12-month acquisition period 
are taken into account as reductions in target's outstanding stock for 
purposes of determining whether target stock purchased by the purchasing 
corporation in the 12-month acquisition period satisfies the percentage 
ownership requirements of section 338(d)(3).
    (iii) Redemptions from the purchasing corporation or related persons 
during 12-month acquisition period--(A) General rule. For purposes of 
the percentage ownership requirements of section 338(d)(3), a redemption 
of target stock during the 12-month acquisition period from the 
purchasing corporation or from any person related to the purchasing 
corporation is not taken into account as a reduction in target's 
outstanding stock.
    (B) Exception for certain redemptions from related corporations. A 
redemption of target stock during the 12-month acquisition period from a 
corporation related to the purchasing corporation is taken into account 
as a reduction in target's outstanding stock to the extent that the 
redeemed stock would have been considered purchased by the purchasing 
corporation (because of section 338(h)(3)(C)) during the 12-month 
acquisition period if the redeemed stock had been acquired by the 
purchasing corporation from the related corporation on the day of the 
redemption. See paragraph (b)(3) of this section.
    (iv) Examples. The following examples illustrate this paragraph 
(b)(5):

    Example 1. QSP on stock purchase date; redemption from unrelated 
person during 12-month period. A owns all 100 shares of T stock. On 
January 1 of Year 1, P purchases 40 shares of the T stock from A. On 
July 1 of Year 1, T redeems 25 shares from A. On December 1 of Year 1, P 
purchases 20 shares of the T stock from A. P makes a qualified stock 
purchase of T on December 1 of Year 1, because the 60 shares of T stock 
purchased by P within the 12-month period ending on

[[Page 110]]

that date satisfy the 80-percent ownership requirements of section 
338(d)(3) (i.e., 60/75 shares), determined by taking into account the 
redemption of 25 shares.
    Example 2. QSP on stock redemption date; redemption from unrelated 
person during 12-month period. The facts are the same as in Example 1, 
except that P purchases 60 shares of T stock on January 1 of Year 1 and 
none on December 1 of Year 1. P makes a qualified stock purchase of T on 
July 1 of Year 1, because that is the first day on which the T stock 
purchased by P within the preceding 12-month period satisfies the 80-
percent ownership requirements of section 338(d)(3) (i.e., 60/75 
shares), determined by taking into account the redemption of 25 shares.
    Example 3. Redemption from purchasing corporation not taken into 
account. On December 15 of Year 1, T redeems 30 percent of its stock 
from P. The redeemed stock was held by P for several years and 
constituted P's total interest in T. On December 1 of Year 2, P 
purchases the remaining T stock from A. P does not make a qualified 
stock purchase of T on December 1 of Year 2. For purposes of the 80-
percent ownership requirements of section 338(d)(3), the redemption of 
P's T stock on December 15 of Year 1 is not taken into account as a 
reduction in T's outstanding stock.
    Example 4. Redemption from related person taken into account. On 
January 1 of Year 1, P purchases 60 of the 100 shares of X stock. On 
that date, X owns 40 of the 100 shares of T stock. On April 1 of Year 1, 
T redeems X's T stock and P purchases the remaining 60 shares of T stock 
from an unrelated person. For purposes of the 80-percent ownership 
requirements of section 338(d)(3), the redemption of the T stock from X 
(a person related to P) is taken into account as a reduction in T's 
outstanding stock. If P had purchased the 40 redeemed shares from X on 
April 1 of Year 1, all 40 of the shares would have been considered 
purchased (because of section 338(h)(3)(C)(i)) during the 12-month 
period ending on April 1 of Year 1 (24 of the 40 shares would have been 
considered purchased by P on January 1 of Year 1 and the remaining 16 
shares would have been considered purchased by P on April 1 of Year 1). 
See paragraph (b)(3) of this section. Accordingly, P makes a qualified 
stock purchase of T on April 1 of Year 1, because the 60 shares of T 
stock purchased by P on that date satisfy the 80-percent ownership 
requirements of section 338(d)(3) (i.e., 60/60 shares), determined by 
taking into account the redemption of 40 shares.

    (c) Effect of post-acquisition events on eligibility for section 338 
election--(1) Post-acquisition elimination of target. (i) The purchasing 
corporation may make an election under section 338 for target even 
though target is liquidated on or after the acquisition date. If target 
liquidates on the acquisition date, the liquidation is considered to 
occur on the following day and immediately after new target's deemed 
purchase of assets. The purchasing corporation may also make an election 
under section 338 for target even though target is merged into another 
corporation, or otherwise disposed of by the purchasing corporation 
provided that, under the facts and circumstances, the purchasing 
corporation is considered for tax purposes as the purchaser of the 
target stock. See Sec. 1.338(h)(10)-1(c)(2) for special rules 
concerning section 338(h)(10) elections in certain multi-step 
transactions.
    (ii) The following examples illustrate this paragraph (c)(1):

    Example 1. On January 1 of Year 1, P purchases 100 percent of the 
outstanding common stock of T. On June 1 of Year 1, P sells the T stock 
to an unrelated person. Assuming that P is considered for tax purposes 
as the purchaser of the T stock, P remains eligible, after June 1 of 
Year 1, to make a section 338 election for T that results in a deemed 
asset sale of T's assets on January 1 of Year 1.
    Example 2. On January 1 of Year 1, P makes a qualified stock 
purchase of T. On that date, T owns the stock of T1. On March 1 of Year 
1, T sells the T1 stock to an unrelated person. On April 1 of Year 1, P 
makes a section 338 election for T. Notwithstanding that the T1 stock 
was sold on March 1 of Year 1, the section 338 election for T on April 1 
of Year 1 results in a qualified stock purchase by T of T1 on January 1 
of Year 1. See paragraph (b)(4)(i) of this section.

    (2) Post-acquisition elimination of the purchasing corporation. An 
election under section 338 may be made for target after the acquisition 
of assets of the purchasing corporation by another corporation in a 
transaction described in section 381(a), provided that the purchasing 
corporation is considered for tax purposes as the purchaser of the 
target stock. The acquiring corporation in the section 381(a) 
transaction may make an election under section 338 for target.
    (d) Consequences of post-acquisition elimination of target where 
section 338 election not made--(1) Scope. The rules of this paragraph 
(d) apply to the

[[Page 111]]

transfer of target assets to the purchasing corporation (or another 
member of the same affiliated group as the purchasing corporation) (the 
transferee) following a qualified stock purchase of target stock, if the 
purchasing corporation does not make a section 338 election for target. 
Notwithstanding the rules of this paragraph (d), section 354(a) (and so 
much of section 356 as relates to section 354) cannot apply to any 
person other than the purchasing corporation or another member of the 
same affiliated group as the purchasing corporation unless the transfer 
of target assets is pursuant to a reorganization as determined without 
regard to this paragraph (d).
    (2) Continuity of interest. By virtue of section 338, in determining 
whether the continuity of interest requirement of Sec. 1.368-1(b) is 
satisfied on the transfer of assets from target to the transferee, the 
purchasing corporation's target stock acquired in the qualified stock 
purchase represents an interest on the part of a person who was an owner 
of the target's business enterprise prior to the transfer that can be 
continued in a reorganization.
    (3) Control requirement. By virtue of section 338, the acquisition 
of target stock in the qualified stock purchase will not prevent the 
purchasing corporation from qualifying as a shareholder of the target 
transferor for the purpose of determining whether, immediately after the 
transfer of target assets, a shareholder of the transferor is in control 
of the corporation to which the assets are transferred within the 
meaning of section 368(a)(1)(D).
    (4) Solely for voting stock requirement. By virtue of section 338, 
the acquisition of target stock in the qualified stock purchase for 
consideration other than voting stock will not prevent the subsequent 
transfer of target assets from satisfying the solely for voting stock 
requirement for purposes of determining if the transfer of target assets 
qualifies as a reorganization under section 368(a)(1)(C).
    (5) Example. The following example illustrates this paragraph (d):

    Example. (i) Facts. P, T, and X are domestic corporations. T and X 
each operate a trade or business. A and K, individuals unrelated to P, 
own 85 and 15 percent, respectively, of the stock of T. P owns all of 
the stock of X. The total adjusted basis of T's property exceeds the sum 
of T's liabilities plus the amount of liabilities to which T's property 
is subject. P purchases all of A's T stock for cash in a qualified stock 
purchase. P does not make an election under section 338(g) with respect 
to its acquisition of T stock. Shortly after the acquisition date, and 
as part of the same plan, T merges under applicable state law into X in 
a transaction that, but for the question of continuity of interest, 
satisfies all the requirements of section 368(a)(1)(A). In the merger, 
all of T's assets are transferred to X. P and K receive X stock in 
exchange for their T stock. P intends to retain the stock of X 
indefinitely.
    (ii) Status of transfer as a reorganization. By virtue of section 
338, for the purpose of determining whether the continuity of interest 
requirement of Sec. 1.368-1(b) is satisfied, P's T stock acquired in 
the qualified stock purchase represents an interest on the part of a 
person who was an owner of T's business enterprise prior to the transfer 
that can be continued in a reorganization through P's continuing 
ownership of X. Thus, the continuity of interest requirement is 
satisfied and the merger of T into X is a reorganization within the 
meaning of section 368(a)(1)(A). Moreover, by virtue of section 338, the 
requirement of section 368(a)(1)(D) that a target shareholder control 
the transferee immediately after the transfer is satisfied because P 
controls X immediately after the transfer. In addition, all of T's 
assets are transferred to X in the merger and P and K receive the X 
stock exchanged therefor in pursuance of the plan of reorganization. 
Thus, the merger of T into X is also a reorganization within the meaning 
of section 368(a)(1)(D).
    (iii) Treatment of T and X. Under section 361(a), T recognizes no 
gain or loss in the merger. Under section 362(b), X's basis in the 
assets received in the merger is the same as the basis of the assets in 
T's hands. X succeeds to and takes into account the items of T as 
provided in section 381.
    (iv) Treatment of P. By virtue of section 338, the transfer of T 
assets to X is a reorganization. Pursuant to that reorganization, P 
exchanges its T stock solely for stock of X, a party to the 
reorganization. Because P is the purchasing corporation, section 354 
applies to P's exchange of T stock for X stock in the merger of T into 
X. Thus, P recognizes no gain or loss on the exchange. Under section 
358, P's basis in the X stock received in the exchange is the same as 
the basis of P's T stock exchanged therefor.
    (v) Treatment of K. Because K is not the purchasing corporation (or 
an affiliate thereof), section 354 cannot apply to K's exchange of T 
stock for X stock in the merger of T into X unless the transfer of T's 
assets is pursuant to a reorganization as determined

[[Page 112]]

without regard to this paragraph (d). Under general principles of tax 
law applicable to reorganizations, the continuity of interest 
requirement is not satisfied because P's stock purchase and the merger 
of T into X are pursuant to an integrated transaction in which A, the 
owner of 85 percent of the stock of T, received solely cash in exchange 
for A's T stock. See, e.g., Sec. 1.368-1(e)(1)(i); Yoc Heating v. 
Commissioner, 61 T.C. 168 (1973); Kass v. Commissioner, 60 T.C. 218 
(1973), aff'd, 491 F.2d 749 (3d Cir. 1974). Thus, the requisite 
continuity of interest under Sec. 1.368-1(b) is lacking and section 354 
does not apply to K's exchange of T stock for X stock. K recognizes gain 
or loss, if any, pursuant to section 1001(c) with respect to its T 
stock.

[T.D. 8940, 66 FR 9929, Feb. 13, 2001; 66 FR 17363, Mar. 30, 2001, as 
amended by T.D. 9071, 68 FR 40768, July 9, 2003; T.D. 9271, 71 FR 38075, 
July 5, 2006]



Sec. 1.338-4  Aggregate deemed sale price; various aspects of taxation of 

the deemed asset sale.

    (a) Scope. This section provides rules under section 338(a)(1) to 
determine the aggregate deemed sale price (ADSP) for target. ADSP is the 
amount for which old target is deemed to have sold all of its assets in 
the deemed asset sale. ADSP is allocated among target's assets in 
accordance with Sec. 1.338-6 to determine the amount for which each 
asset is deemed to have been sold. When a subsequent increase or 
decrease is required under general principles of tax law with respect to 
an element of ADSP, the redetermined ADSP is allocated among target's 
assets in accordance with Sec. 1.338-7. This Sec. 1.338-4 also 
provides rules regarding the recognition of gain or loss on the deemed 
sale of target affiliate stock. Notwithstanding section 
338(h)(6)(B)(ii), stock held by a target affiliate in a foreign 
corporation or in a corporation that is a DISC or that is described in 
section 1248(e) is not excluded from the operation of section 338.
    (b) Determination of ADSP--(1) General rule. ADSP is the sum of--
    (i) The grossed-up amount realized on the sale to the purchasing 
corporation of the purchasing corporation's recently purchased target 
stock (as defined in section 338(b)(6)(A)); and
    (ii) The liabilities of old target.
    (2) Time and amount of ADSP--(i) Original determination. ADSP is 
initially determined at the beginning of the day after the acquisition 
date of target. General principles of tax law apply in determining the 
timing and amount of the elements of ADSP.
    (ii) Redetermination of ADSP. ADSP is redetermined at such time and 
in such amount as an increase or decrease would be required, under 
general principles of tax law, for the elements of ADSP. For example, 
ADSP is redetermined because of an increase or decrease in the amount 
realized for recently purchased stock or because liabilities not 
originally taken into account in determining ADSP are subsequently taken 
into account. Increases or decreases with respect to the elements of 
ADSP result in the reallocation of ADSP among target's assets under 
Sec. 1.338-7.
    (iii) Example. The following example illustrates this paragraph 
(b)(2):

    Example. In Year 1, T, a manufacturer, purchases a customized 
delivery truck from X with purchase money indebtedness having a stated 
principal amount of $100,000. P acquires all of the stock of T in Year 3 
for $700,000 and makes a section 338 election for T. Assume T has no 
liabilities other than its purchase money indebtedness to X. In Year 4, 
when T is neither insolvent nor in a title 11 case, T and X agree to 
reduce the amount of the purchase money indebtedness to $80,000. Assume 
further that the reduction would be a purchase price reduction under 
section 108(e)(5). T and X's agreement to reduce the amount of the 
purchase money indebtedness would not, under general principles of tax 
law that would apply if the deemed asset sale had actually occurred, 
change the amount of liabilities of old target taken into account in 
determining its amount realized. Accordingly, ADSP is not redetermined 
at the time of the reduction. See Sec. 1.338-5(b)(2)(iii) Example 1 for 
the effect on AGUB.

    (c) Grossed-up amount realized on the sale to the purchasing 
corporation of the purchasing corporation's recently purchased target 
stock--(1) Determination of amount. The grossed-up amount realized on 
the sale to the purchasing corporation of the purchasing corporation's 
recently purchased target stock is an amount equal to--
    (i) The amount realized on the sale to the purchasing corporation of 
the purchasing corporation's recently purchased target stock determined 
as if the selling shareholder(s) were required to use old target's 
accounting methods

[[Page 113]]

and characteristics and the installment method were not available and 
determined without regard to the selling costs taken into account under 
paragraph (c)(1)(iii) of this section;
    (ii) Divided by the percentage of target stock (by value, determined 
on the acquisition date) attributable to that recently purchased target 
stock;
    (iii) Less the selling costs incurred by the selling shareholders in 
connection with the sale to the purchasing corporation of the purchasing 
corporation's recently purchased target stock that reduce their amount 
realized on the sale of the stock (e.g., brokerage commissions and any 
similar costs to sell the stock).
    (2) Example. The following example illustrates this paragraph (c):

    Example. T has two classes of stock outstanding, voting common stock 
and preferred stock described in section 1504(a)(4). On March 1 of Year 
1, P purchases 40 percent of the outstanding T stock from S1 for $500, 
20 percent of the outstanding T stock from S2 for $225, and 20 percent 
of the outstanding T stock from S3 for $275. On that date, the fair 
market value of all the T voting common stock is $1,250 and the 
preferred stock $750. S1, S2, and S3 incur $40, $35, and $25 
respectively of selling costs. S1 continues to own the remaining 20 
percent of the outstanding T stock. The grossed-up amount realized on 
the sale to P of P's recently purchased T stock is calculated as 
follows: The total amount realized (without regard to selling costs) is 
$1,000 (500 + 225 + 275). The percentage of T stock by value on the 
acquisition date attributable to the recently purchased T stock is 50% 
(1,000/(1,250 + 750)). The selling costs are $100 (40 + 35 + 25). The 
grossed-up amount realized is $1,900 (1,000/.5 - 100).

    (d) Liabilities of old target--(1) In general. In general, the 
liabilities of old target are measured as of the beginning of the day 
after the acquisition date. (But see Sec. 1.338-1(d) (regarding certain 
transactions on the acquisition date).) In order to be taken into 
account in ADSP, a liability must be a liability of target that is 
properly taken into account in amount realized under general principles 
of tax law that would apply if old target had sold its assets to an 
unrelated person for consideration that included the discharge of its 
liabilities. See Sec. 1.1001-2(a). Such liabilities may include 
liabilities for the tax consequences resulting from the deemed sale.
    (2) Time and amount of liabilities. The time for taking into account 
liabilities of old target in determining ADSP and the amount of the 
liabilities taken into account is determined as if old target had sold 
its assets to an unrelated person for consideration that included the 
discharge of the liabilities by the unrelated person. For example, if no 
amount of a target liability is properly taken into account in amount 
realized as of the beginning of the day after the acquisition date, the 
liability is not initially taken into account in determining ADSP 
(although it may be taken into account at some later date).
    (e) Deemed sale tax consequences. Gain or loss on each asset in the 
deemed sale is computed by reference to the ADSP allocated to that 
asset. ADSP is allocated under the rules of Sec. 1.338-6. Though deemed 
sale tax consequences may increase or decrease ADSP by creating or 
reducing a tax liability, the amount of the tax liability itself may be 
a function of the size of the deemed sale tax consequences. Thus, these 
determinations may require trial and error computations.
    (f) Other rules apply in determining ADSP. ADSP may not be applied 
in such a way as to contravene other applicable rules. For example, a 
capital loss cannot be applied to reduce ordinary income in calculating 
the tax liability on the deemed sale for purposes of determining ADSP.
    (g) Examples. The following examples illustrate this section. For 
purposes of the examples in this paragraph (g), unless otherwise stated, 
T is a calendar year taxpayer that files separate returns and that has 
no loss, tax credit, or other carryovers to Year 1. Depreciation for 
Year 1 is not taken into account. T has no liabilities other than the 
Federal income tax liability resulting from the deemed asset sale, and 
the T shareholders have no selling costs. Assume that T's tax rate for 
any ordinary income or net capital gain resulting from the deemed sale 
of assets is 34 percent and that any capital loss is offset by capital 
gain. On July 1 of Year 1, P purchases all of the stock of T and makes a 
section 338 election for T. The examples are as follows:


[[Page 114]]


    Example 1. One class. (i) On July 1 of Year 1, T's only asset is an 
item of section 1245 property with an adjusted basis to T of $50,400, a 
recomputed basis of $80,000, and a fair market value of $100,000. P 
purchases all of the T stock for $75,000, which also equals the amount 
realized for the stock determined as if the selling shareholder(s) were 
required to use old target's accounting methods and characteristics.
    (ii) ADSP is determined as follows (for purposes of this section 
(g), G is the grossed-up amount realized on the sale to P of P's 
recently purchased T stock, L is T's liabilities other than T's tax 
liability for the deemed sale tax consequences, TR is the 
applicable tax rate, and B is the adjusted basis of the asset deemed 
sold):

ADSP = G + L + TR x (ADSP-B)
ADSP = ($75,000/1) + $0 + .34 x (ADSP - $50,400)
ADSP = $75,000 + .34ADSP - $17,136 .66ADSP = $57,864
ADSP = $87,672.72

    (iii) Because ADSP for T ($87,672.72) does not exceed the fair 
market value of T's asset ($100,000), a Class V asset, T's entire ADSP 
is allocated to that asset. Thus, T's deemed sale results in $37,272.72 
of taxable income (consisting of $29,600 of ordinary income and 
$7,672.72 of capital gain).
    (iv) The facts are the same as in paragraph (i) of this Example 1, 
except that on July 1 of Year 1, P purchases only 80 of the 100 shares 
of T stock for $60,000. The grossed-up amount realized on the sale to P 
of P's recently purchased T stock (G) is $75,000 ($60,000/.8). 
Consequently, ADSP and the deemed sale tax consequences are the same as 
in paragraphs (ii) and (iii) of this Example 1.
    (v) The facts are the same as in paragraph (i) of this Example 1, 
except that T also has goodwill (a Class VII asset) with an appraised 
value of $10,000. The results are the same as in paragraphs (ii) and 
(iii) of this Example 1. Because ADSP does not exceed the fair market 
value of the Class V asset, no amount is allocated to the Class VII 
asset (goodwill).
    Example 2. More than one class. (i) P purchases all of the T stock 
for $140,000, which also equals the amount realized for the stock 
determined as if the selling shareholder(s) were required to use old 
target's accounting methods and characteristics. On July 1 of Year 1, T 
has liabilities (not including the tax liability for the deemed sale tax 
consequences) of $50,000, cash (a Class I asset) of $10,000, actively 
traded securities (a Class II asset) with a basis of $4,000 and a fair 
market value of $10,000, goodwill (a Class VII asset) with a basis of 
$3,000, and the following Class V assets:

------------------------------------------------------------------------
                                                               Ratio of
                                                              asset FMV
              Asset                   Basis         FMV        to total
                                                             Class V FMV
------------------------------------------------------------------------
Land.............................       $5,000      $35,000          .14
Building.........................       10,000       50,000          .20
Equipment A (Recomputed basis            5,000       90,000          .36
 $80,000)........................
Equipment B (Recomputed basis           10,000       75,000          .30
 $20,000)........................
                                  --------------------------------------
    Totals.......................      $30,000     $250,000         1.00
------------------------------------------------------------------------

    (ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to the 
cash and $10,000 to the actively traded securities. The amount allocated 
to an asset (other than a Class VII asset) cannot exceed its fair market 
value (however, the fair market value of any property subject to 
nonrecourse indebtedness is treated as being not less than the amount of 
such indebtedness; see Sec. 1.338-6(a)(2)). See Sec. 1.338-6(c)(1) 
(relating to fair market value limitation).
    (iii) The portion of ADSP allocable to the Class V assets is 
preliminarily determined as follows (in the formula, the amount 
allocated to the Class I assets is referred to as I and the amount 
allocated to the Class II assets as II):

ADSPV = (G-(I + II)) + L+ TR x [(II - 
BII) + (ADSPV - BV)]
ADSPV = ($140,000 - ($10,000 + $10,000)) + $50,000 + .34 x 
[($10,000 - $4,000) + (ADSPV - ($5,000 + $10,000 + $5,000 + 
$10,000))]
ADSPV = $161,840 + .34ADSPV
.66 ADSPV = $161,840
ADSPV = $245,212.12

    (iv) Because, under the preliminary calculations of ADSP, the amount 
to be allocated to the Class I, II, III, IV, V, and VI assets does not 
exceed their aggregate fair market value, no ADSP amount is allocated to 
goodwill. Accordingly, the deemed sale of the goodwill results in a 
capital loss of $3,000. The portion of ADSP allocable to the Class V 
assets is finally determined by taking into account this loss as 
follows:

ADSPV = (G - (I + II)) + L + T R x [(II - 
BII) + (ADSPV - BV) + 
(ADSPVII - B VII)]

[[Page 115]]

ADSPV = ($140,000 - ($10,000 + $10,000))+ $50,000 + .34 x 
[($10,000 - $4,000) + (ADSPV - $30,000) + ($0 - $3,000)]
ADSPV = $160,820 + .34ADSPV
.66 ADSPV = $160,820
ADSPV = $243,666.67

    (v) The allocation of ADSPV among the Class V assets is 
in proportion to their fair market values, as follows:

------------------------------------------------------------------------
             Asset                    ADSP                 Gain
------------------------------------------------------------------------
Land..........................        $34,113.33  $29,113.33 (capital
                                                   gain).
Building......................         48,733.34  38,733.34 (capital
                                                   gain).
Equipment A...................         87,720.00  82,720.00 (75,000
                                                   ordinary income 7,720
                                                   capital gain).
Equipment B...................         73,100.00  63,100.00 (10,000
                                                   ordinary income
                                                   53,100 capital gain).
                               -----------------------------------------
    Totals....................        243,666.67  213,666.67.
------------------------------------------------------------------------

    Example 3. More than one class. (i) The facts are the same as in 
Example 2, except that P purchases the T stock for $150,000, rather than 
$140,000. The amount realized for the stock determined as if the selling 
shareholder(s) were required to use old target's accounting methods and 
characteristics is also $150,000.
    (ii) As in Example 2, ADSP exceeds $20,000. Thus, $10,000 of ADSP is 
allocated to the cash and $10,000 to the actively traded securities.
    (iii) The portion of ADSP allocable to the Class V assets as 
preliminarily determined under the formula set forth in paragraph (iii) 
of Example 2 is $260,363.64. The amount allocated to the Class V assets 
cannot exceed their aggregate fair market value ($250,000). Thus, 
preliminarily, the ADSP amount allocated to Class V assets is $250,000.
    (iv) Based on the preliminary allocation, the ADSP is determined as 
follows (in the formula, the amount allocated to the Class I assets is 
referred to as I, the amount allocated to the Class II assets as II, and 
the amount allocated to the Class V assets as V):

ADSP = G + L + TR x [(II - BII) + (V - 
BV) + (ADSP - (I + II + V + BVII))]
ADSP = $150,000 + $50,000 + .34 x [($10,000 - $4,000) + ($250,000 - 
$30,000) + (ADSP - ($10,000 + $10,000 + $250,000 + $3,000))]
ADSP = $200,000 + .34ADSP - $15,980
.66ADSP = $184,020
ADSP = $278,818.18

    (v) Because ADSP as determined exceeds the aggregate fair market 
value of the Class I, II, III, IV, V, and VI assets, the $250,000 amount 
preliminarily allocated to the Class V assets is appropriate. Thus, the 
amount of ADSP allocated to Class V assets equals their aggregate fair 
market value ($250,000), and the allocated ADSP amount for each Class V 
asset is its fair market value. Further, because there are no Class VI 
assets, the allocable ADSP amount for the Class VII asset (goodwill) is 
$8,818.18 (the excess of ADSP over the aggregate ADSP amounts for the 
Class I, II, III, IV, V and VI assets).
    Example 4. Amount allocated to T1 stock. (i) The facts are the same 
as in Example 2, except that T owns all of the T1 stock (instead of the 
building), and T1's only asset is the building. The T1 stock and the 
building each have a fair market value of $50,000, and the building has 
a basis of $10,000. A section 338 election is made for T1 (as well as 
T), and T1 has no liabilities other than the tax liability for the 
deemed sale tax consequences. T is the common parent of a consolidated 
group filing a final consolidated return described in Sec. 1.338-
10(a)(1).
    (ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to the 
cash and $10,000 to the actively traded securities.
    (iii) Because T does not recognize any gain on the deemed sale of 
the T1 stock under paragraph (h)(2) of this section, appropriate 
adjustments must be made to reflect accurately the fair market value of 
the T and T1 assets in determining the allocation of ADSP among T's 
Class V assets (including the T1 stock). In preliminarily calculating 
ADSPV in this case, the T1 stock can be disregarded and, 
because T owns all of the T1 stock, the T1 asset can be treated as a T 
asset. Under this assumption, ADSPV is $243,666.67. See 
paragraph (iv) of Example 2.
    (iv) Because the portion of the preliminary ADSP allocable to Class 
V assets ($243,666.67) does not exceed their fair market value 
($250,000), no amount is allocated to Class VII assets for T. Further, 
this amount ($243,666.67) is allocated among T's Class V assets in 
proportion to their fair market values. See paragraph (v) of Example 2. 
Tentatively, $48,733.34 of this amount is allocated to the T1 stock.
    (v) The amount tentatively allocated to the T1 stock, however, 
reflects the tax incurred on the deemed sale of the T1 asset equal to 
$13,169.34 (.34x($48,733.34-$10,000)). Thus, the ADSP allocable to the 
Class V assets of T, and the ADSP allocable to the T1 stock, as 
preliminarily calculated, each must be reduced by $13,169.34. 
Consequently, these amounts, respectively, are $230,497.33 and 
$35,564.00. In determining ADSP for T1,

[[Page 116]]

the grossed-up amount realized on the deemed sale to new T of new T's 
recently purchased T1 stock is $35,564.00.
    (vi) The facts are the same as in paragraph (i) of this Example 4, 
except that the T1 building has a $12,500 basis and a $62,500 value, all 
of the outstanding T1 stock has a $62,500 value, and T owns 80 percent 
of the T1 stock. In preliminarily calculating ADSPV, the T1 
stock can be disregarded but, because T owns only 80 percent of the T1 
stock, only 80 percent of T1 asset basis and value should be taken into 
account in calculating T's ADSP. By taking into account 80 percent of 
these amounts, the remaining calculations and results are the same as in 
paragraphs (ii), (iii), (iv), and (v) of this Example 4, except that the 
grossed-up amount realized on the sale of the recently purchased T1 
stock is $44,455.00 ($35,564.00/0.8).

    (h) Deemed sale of target affiliate stock--(1) Scope. This paragraph 
(h) prescribes rules relating to the treatment of gain or loss realized 
on the deemed sale of stock of a target affiliate when a section 338 
election (but not a section 338(h)(10) election) is made for the target 
affiliate. For purposes of this paragraph (h), the definition of 
domestic corporation in Sec. 1.338-2(c)(9) is applied without the 
exclusion therein for DISCs, corporations described in section 1248(e), 
and corporations to which an election under section 936 applies.
    (2) In general. Except as otherwise provided in this paragraph (h), 
if a section 338 election is made for target, target recognizes no gain 
or loss on the deemed sale of stock of a target affiliate having the 
same acquisition date and for which a section 338 election is made if--
    (i) Target directly owns stock in the target affiliate satisfying 
the requirements of section 1504(a)(2);
    (ii) Target and the target affiliate are members of a consolidated 
group filing a final consolidated return described in Sec. 1.338-
10(a)(1); or
    (iii) Target and the target affiliate file a combined return under 
Sec. 1.338-10(a)(4).
    (3) Deemed sale of foreign target affiliate by a domestic target. A 
domestic target recognizes gain or loss on the deemed sale of stock of a 
foreign target affiliate. For the proper treatment of such gain or loss, 
see, e.g., sections 1246, 1248, 1291 et seq., and 338(h)(16) and Sec. 
1.338-9.
    (4) Deemed sale producing effectively connected income. A foreign 
target recognizes gain or loss on the deemed sale of stock of a foreign 
target affiliate to the extent that such gain or loss is effectively 
connected (or treated as effectively connected) with the conduct of a 
trade or business in the United States.
    (5) Deemed sale of insurance company target affiliate electing under 
section 953(d). A domestic target recognizes gain (but not loss) on the 
deemed sale of stock of a target affiliate that has in effect an 
election under section 953(d) in an amount equal to the lesser of the 
gain realized or the earnings and profits described in section 
953(d)(4)(B).
    (6) Deemed sale of DISC target affiliate. A foreign or domestic 
target recognizes gain (but not loss) on the deemed sale of stock of a 
target affiliate that is a DISC or a former DISC (as defined in section 
992(a)) in an amount equal to the lesser of the gain realized or the 
amount of accumulated DISC income determined with respect to such stock 
under section 995(c). Such gain is included in gross income as a 
dividend as provided in sections 995(c)(2) and 996(g).
    (7) Anti-stuffing rule. If an asset the adjusted basis of which 
exceeds its fair market value is contributed or transferred to a target 
affiliate as transferred basis property (within the meaning of section 
7701(a)(43)) and a purpose of such transaction is to reduce the gain (or 
increase the loss) recognized on the deemed sale of such target 
affiliate's stock, the gain or loss recognized by target on the deemed 
sale of stock of the target affiliate is determined as if such asset had 
not been contributed or transferred.
    (8) Examples. The following examples illustrate this paragraph (h):

    Example 1. (i) P makes a qualified stock purchase of T and makes a 
section 338 election for T. T's sole asset, all of the T1 stock, has a 
basis of $50 and a fair market value of $150. T's deemed purchase of the 
T1 stock results in a qualified stock purchase of T1 and a section 338 
election is made for T1. T1's assets have a basis of $50 and a fair 
market value of $150.
    (ii) T realizes $100 of gain on the deemed sale of the T1 stock, but 
the gain is not recognized because T directly owns stock in T1 
satisfying the requirements of section 1504(a)(2) and a section 338 
election is made for T1.

[[Page 117]]

    (iii) T1 recognizes gain of $100 on the deemed sale of its assets.
    Example 2. The facts are the same as in Example 1, except that P 
does not make a section 338 election for T1. Because a section 338 
election is not made for T1, the $100 gain realized by T on the deemed 
sale of the T1 stock is recognized.
    Example 3. (i) P makes a qualified stock purchase of T and makes a 
section 338 election for T. T owns all of the stock of T1 and T2. T's 
deemed purchase of the T1 and T2 stock results in a qualified stock 
purchase of T1 and T2 and section 338 elections are made for T1 and T2. 
T1 and T2 each own 50 percent of the vote and value of T3 stock. The 
deemed purchases by T1 and T2 of the T3 stock result in a qualified 
stock purchase of T3 and a section 338 election is made for T3. T is the 
common parent of a consolidated group and all of the deemed asset sales 
are reported on the T group's final consolidated return. See Sec. 
1.338-10(a)(1).
    (ii) Because T, T1, T2 and T3 are members of a consolidated group 
filing a final consolidated return, no gain or loss is recognized by T, 
T1 or T2 on their respective deemed sales of target affiliate stock.
    Example 4. (i) T's sole asset, all of the FT1 stock, has a basis of 
$25 and a fair market value of $150. FT1's sole asset, all of the FT2 
stock, has a basis of $75 and a fair market value of $150. FT1 and FT2 
each have $50 of accumulated earnings and profits for purposes of 
section 1248(c) and (d). FT2's assets have a basis of $125 and a fair 
market value of $150, and their sale would not generate subpart F income 
under section 951. The sale of the FT2 stock or assets would not 
generate income effectively connected with the conduct of a trade or 
business within the United States. FT1 does not have an election in 
effect under section 953(d) and neither FT1 nor FT2 is a passive foreign 
investment company.
    (ii) P makes a qualified stock purchase of T and makes a section 338 
election for T. T's deemed purchase of the FT1 stock results in a 
qualified stock purchase of FT1 and a section 338 election is made for 
FT1. Similarly, FT1's deemed purchase of the FT2 stock results in a 
qualified stock purchase of FT2 and a section 338 election is made for 
FT2.
    (iii) T recognizes $125 of gain on the deemed sale of the FT1 stock 
under paragraph (h)(3) of this section. FT1 does not recognize $75 of 
gain on the deemed sale of the FT2 stock under paragraph (h)(2) of this 
section. FT2 recognizes $25 of gain on the deemed sale of its assets. 
The $125 gain T recognizes on the deemed sale of the FT1 stock is 
included in T's income as a dividend under section 1248, because FT1 and 
FT2 have sufficient earnings and profits for full recharacterization 
($50 of accumulated earnings and profits in FT1, $50 of accumulated 
earnings and profits in FT2, and $25 of deemed sale earnings and profits 
in FT2). Section 1.338-9(b). For purposes of sections 901 through 908, 
the source and foreign tax credit limitation basket of $25 of the 
recharacterized gain on the deemed sale of the FT1 stock is determined 
under section 338(h)(16).

[T.D. 8940, 66 FR 9929, Feb. 13, 2001; 66 FR 17466, Mar. 30, 2001]



Sec. 1.338-5  Adjusted grossed-up basis.

    (a) Scope. This section provides rules under section 338(b) to 
determine the adjusted grossed-up basis (AGUB) for target. AGUB is the 
amount for which new target is deemed to have purchased all of its 
assets in the deemed purchase under section 338(a)(2). AGUB is allocated 
among target's assets in accordance with Sec. 1.338-6 to determine the 
price at which the assets are deemed to have been purchased. When a 
subsequent increase or decrease with respect to an element of AGUB is 
required under general principles of tax law, redetermined AGUB is 
allocated among target's assets in accordance with Sec. 1.338-7.
    (b) Determination of AGUB--(1) General rule. AGUB is the sum of--
    (i) The grossed-up basis in the purchasing corporation's recently 
purchased target stock;
    (ii) The purchasing corporation's basis in nonrecently purchased 
target stock; and
    (iii) The liabilities of new target.
    (2) Time and amount of AGUB--(i) Original determination. AGUB is 
initially determined at the beginning of the day after the acquisition 
date of target. General principles of tax law apply in determining the 
timing and amount of the elements of AGUB.
    (ii) Redetermination of AGUB. AGUB is redetermined at such time and 
in such amount as an increase or decrease would be required, under 
general principles of tax law, with respect to an element of AGUB. For 
example, AGUB is redetermined because of an increase or decrease in the 
amount paid or incurred for recently purchased stock or nonrecently 
purchased stock or because liabilities not originally taken into account 
in determining AGUB are subsequently taken into account. An increase or 
decrease to one element of AGUB also may cause an increase or decrease 
to another element of AGUB.

[[Page 118]]

For example, if there is an increase in the amount paid or incurred for 
recently purchased stock after the acquisition date, any increase in the 
basis of nonrecently purchased stock because a gain recognition election 
was made is also taken into account when AGUB is redetermined. Increases 
or decreases with respect to the elements of AGUB result in the 
reallocation of AGUB among target's assets under Sec. 1.338-7.
    (iii) Examples. The following examples illustrate this paragraph 
(b)(2):

    Example 1. In Year 1, T, a manufacturer, purchases a customized 
delivery truck from X with purchase money indebtedness having a stated 
principal amount of $100,000. P acquires all of the stock of T in Year 3 
for $700,000 and makes a section 338 election for T. Assume T has no 
liabilities other than its purchase money indebtedness to X. In Year 4, 
when T is neither insolvent nor in a title 11 case, T and X agree to 
reduce the amount of the purchase money indebtedness to $80,000. Assume 
that the reduction would be a purchase price reduction under section 
108(e)(5). T and X's agreement to reduce the amount of the purchase 
money indebtedness would, under general principles of tax law that would 
apply if the deemed asset sale had actually occurred, change the amount 
of liabilities of old target taken into account in determining its 
basis. Accordingly, AGUB is redetermined at the time of the reduction. 
See paragraph (e)(2) of this section. Thus the purchase price reduction 
affects the basis of the truck only indirectly, through the mechanism of 
Sec. Sec. 1.338-6 and 1.338-7. See Sec. 1.338-4(b)(2)(iii) Example for 
the effect on ADSP.
    Example 2. T, an accrual basis taxpayer, is a chemical manufacturer. 
In Year 1, T is obligated to remediate environmental contamination at 
the site of one of its plants. Assume that all the events have occurred 
that establish the fact of the liability and the amount of the liability 
can be determined with reasonable accuracy but economic performance has 
not occurred with respect to the liability within the meaning of section 
461(h). P acquires all of the stock of T in Year 1 and makes a section 
338 election for T. Assume that, if a corporation unrelated to T had 
actually purchased T's assets and assumed T's obligation to remediate 
the contamination, the corporation would not satisfy the economic 
performance requirements until Year 5. Under section 461(h), the assumed 
liability would not be treated as incurred and taken into account in 
basis until that time. The incurrence of the liability in Year 5 under 
the economic performance rules is an increase in the amount of 
liabilities properly taken into account in basis and results in the 
redetermination of AGUB. (Respecting ADSP, compare Sec. 1.461-4(d)(5), 
which provides that economic performance occurs for old T as the amount 
of the liability is properly taken into account in amount realized on 
the deemed asset sale. Thus ADSP is not redetermined when new T 
satisfies the economic performance requirements.)

    (c) Grossed-up basis of recently purchased stock. The purchasing 
corporation's grossed-up basis of recently purchased target stock (as 
defined in section 338(b)(6)(A)) is an amount equal to--
    (1) The purchasing corporation's basis in recently purchased target 
stock at the beginning of the day after the acquisition date determined 
without regard to the acquisition costs taken into account in paragraph 
(c)(3) of this section;
    (2) Multiplied by a fraction, the numerator of which is 100 minus 
the number that is the percentage of target stock (by value, determined 
on the acquisition date) attributable to the purchasing corporation's 
nonrecently purchased target stock, and the denominator of which is the 
number equal to the percentage of target stock (by value, determined on 
the acquisition date) attributable to the purchasing corporation's 
recently purchased target stock;
    (3) Plus the acquisition costs the purchasing corporation incurred 
in connection with its purchase of the recently purchased stock that are 
capitalized in the basis of such stock (e.g., brokerage commissions and 
any similar costs incurred by the purchasing corporation to acquire the 
stock).
    (d) Basis of nonrecently purchased stock; gain recognition 
election--(1) No gain recognition election. In the absence of a gain 
recognition election under section 338(b)(3) and this section, the 
purchasing corporation retains its basis in the nonrecently purchased 
stock.
    (2) Procedure for making gain recognition election. A gain 
recognition election may be made for nonrecently purchased stock of 
target (or a target affiliate) only if a section 338 election is made 
for target (or the target affiliate). The gain recognition election is 
made by attaching a gain recognition statement to a timely filed Form 
8023 for target. The gain recognition statement must contain the 
information

[[Page 119]]

specified in the form and its instructions. The gain recognition 
election is irrevocable. If a section 338(h)(10) election is made for 
target, see Sec. 1.338(h)(10)-1(d)(1) (providing that the purchasing 
corporation is automatically deemed to have made a gain recognition 
election for its nonrecently purchased T stock).
    (3) Effect of gain recognition election--(i) In general. If the 
purchasing corporation makes a gain recognition election, then for all 
purposes of the Internal Revenue Code--
    (A) The purchasing corporation is treated as if it sold on the 
acquisition date the nonrecently purchased target stock for the basis 
amount determined under paragraph (d)(3)(ii) of this section; and
    (B) The purchasing corporation's basis on the acquisition date in 
nonrecently purchased target stock immediately following the deemed sale 
in paragraph (d)(3)(i)(A) of this section is the basis amount.
    (ii) Basis amount. The basis amount is equal to the amount in 
paragraph (c)(1) of this section (the purchasing corporation's basis in 
recently purchased target stock at the beginning of the day after the 
acquisition date determined without regard to the acquisition costs 
taken into account in paragraph (c)(3) of this section) multiplied by a 
fraction the numerator of which is the percentage of target stock (by 
value, determined on the acquisition date) attributable to the 
purchasing corporation's nonrecently purchased target stock and the 
denominator of which is 100 percent minus the numerator amount. Thus, if 
target has a single class of outstanding stock, the purchasing 
corporation's basis in each share of nonrecently purchased target stock 
after the gain recognition election is equal to the average price per 
share of the purchasing corporation's recently purchased target stock.
    (iii) Losses not recognized. Only gains (unreduced by losses) on the 
nonrecently purchased target stock are recognized.
    (iv) Stock subject to election. The gain recognition election 
applies to--
    (A) All nonrecently purchased target stock; and
    (B) Any nonrecently purchased stock in a target affiliate having the 
same acquisition date as target if such target affiliate stock is held 
by the purchasing corporation on such date.
    (e) Liabilities of new target--(1) In general. The liabilities of 
new target are the liabilities of target as of the beginning of the day 
after the acquisition date (but see Sec. 1.338-1(d) (regarding certain 
transactions on the acquisition date)). In order to be taken into 
account in AGUB, a liability must be a liability of target that is 
properly taken into account in basis under general principles of tax law 
that would apply if new target had acquired its assets from an unrelated 
person for consideration that included discharge of the liabilities of 
that unrelated person. Such liabilities may include liabilities for the 
tax consequences resulting from the deemed sale.
    (2) Time and amount of liabilities. The time for taking into account 
liabilities of old target in determining AGUB and the amount of the 
liabilities taken into account is determined as if new target had 
acquired its assets from an unrelated person for consideration that 
included the discharge of its liabilities.
    (3) Interaction with deemed sale tax consequences. In general, see 
Sec. 1.338-4(e). Although ADSP and AGUB are not necessarily linked, if 
an increase in the amount realized for recently purchased stock of 
target is taken into account after the acquisition date, and if the tax 
on the deemed sale tax consequences is a liability of target, any 
increase in that liability is also taken into account in redetermining 
AGUB.
    (f) Adjustments by the Internal Revenue Service. In connection with 
the examination of a return, the Commissioner may increase (or decrease) 
AGUB under the authority of section 338(b)(2) and allocate such amounts 
to target's assets under the authority of section 338(b)(5) so that AGUB 
and the basis of target's assets properly reflect the cost to the 
purchasing corporation of its interest in target's assets. Such items 
may include distributions from target to the purchasing corporation, 
capital contributions from the purchasing corporation to target during 
the 12-month acquisition period, or acquisitions of

[[Page 120]]

target stock by the purchasing corporation after the acquisition date 
from minority shareholders. See also Sec. 1.338-1(d) (regarding certain 
transactions on the acquisition date).
    (g) Examples. The following examples illustrate this section. For 
purposes of the examples in this paragraph (g), T has no liabilities 
other than the tax liability for the deemed sale tax consequences, T 
shareholders incur no costs in selling the T stock, and P incurs no 
costs in acquiring the T stock. The examples are as follows:

    Example 1. (i) Before July 1 of Year 1, P purchases 10 of the 100 
shares of T stock for $5,000. On July 1 of Year 2, P purchases 80 shares 
of T stock for $60,000 and makes a section 338 election for T. As of 
July 1 of Year 2, T's only asset is raw land with an adjusted basis to T 
of $50,400 and a fair market value of $100,000. T has no loss or tax 
credit carryovers to Year 2. T's marginal tax rate for any ordinary 
income or net capital gain resulting from the deemed asset sale is 34 
percent. The 10 shares purchased before July 1 of Year 1 constitute 
nonrecently purchased T stock with respect to P's qualified stock 
purchase of T stock on July 1 of Year 2.
    (ii) The ADSP formula as applied to these facts is the same as in 
Sec. 1.338-4(g) Example 1. Accordingly, the ADSP for T is $87,672.72. 
The existence of nonrecently purchased T stock is irrelevant for 
purposes of the ADSP formula, because that formula treats P's 
nonrecently purchased T stock in the same manner as T stock not held by 
P.
    (iii) The total tax liability resulting from T's deemed asset sale, 
as calculated under the ADSP formula, is $12,672.72.
    (iv) If P does not make a gain recognition election, the AGUB of new 
T's assets is $85,172.72, determined as follows (In the following 
formula below, GRP is the grossed-up basis in P's recently purchased T 
stock, BNP is P's basis in nonrecently purchased T stock, L is T's 
liabilities, and X is P's acquisition costs for the recently purchased T 
stock):

AGUB = GRP + BNP + L + X
AGUB = $60,000 x [(1 - .1)/.8] + $5,000 + $12,672.72 + 0
AGUB = $85,172.72

    (v) If P makes a gain recognition election, the AGUB of new T's 
assets is $87,672.72, determined as follows:

AGUB = $60,000 x [(1 - .1)/.8] + $60,000 x [(1 - .1)/.8] x [.1/(1 - .1)] 
+ $12,672.72
AGUB = $87,672.72

    (vi) The calculation of AGUB if P makes a gain recognition election 
may be simplified as follows:

AGUB = $60,000/.8 + $12,672.72
AGUB = $87,672.72

    (vii) As a result of the gain recognition election, P's basis in its 
nonrecently purchased T stock is increased from $5,000 to $7,500 (i.e., 
$60,000 x [(1 - .1)/.8] x [.1/(1 - .1)]). Thus, P recognizes a gain in 
Year 2 with respect to its nonrecently purchased T stock of $2,500 
(i.e., $7,500 - $5,000).
    Example 2. On January 1 of Year 1, P purchases one-third of the T 
stock. On March 1 of Year 1, T distributes a dividend to all of its 
shareholders. On April 15 of Year 1, P purchases the remaining T stock 
and makes a section 338 election for T. In appropriate circumstances, 
the Commissioner may decrease the AGUB of T to take into account the 
payment of the dividend and properly reflect the fair market value of 
T's assets deemed purchased.
    Example 3. (i) T's sole asset is a building worth $100,000. At this 
time, T has 100 shares of stock outstanding. On August 1 of Year 1, P 
purchases 10 of the 100 shares of T stock for $8,000. On June 1 of Year 
2, P purchases 50 shares of T stock for $50,000. On June 15 of Year 2, P 
contributes a tract of land to the capital of T and receives 10 
additional shares of T stock as a result of the contribution. Both the 
basis and fair market value of the land at that time are $10,800. On 
June 30 of Year 2, P purchases the remaining 40 shares of T stock for 
$40,000 and makes a section 338 election for T. The AGUB of T is 
$108,800.
    (ii) To prevent the shifting of basis from the contributed property 
to other assets of T, the Commissioner may allocate $10,800 of the AGUB 
to the land, leaving $98,000 to be allocated to the building. See 
paragraph (f) of this section. Otherwise, applying the allocation rules 
of Sec. 1.338-6 would, on these facts, result in an allocation to the 
recently contributed land of an amount less than its value of $10,800, 
with the difference being allocated to the building already held by T.

[T.D. 8940, 66 FR 9929, Feb. 13, 2001]



Sec. 1.338-6  Allocation of ADSP and AGUB among target assets.

    (a) Scope--(1) In general. This section prescribes rules for 
allocating ADSP and AGUB among the acquisition date assets of a target 
for which a section 338 election is made.
    (2) Fair market value--(i) In general. Generally, the fair market 
value of an asset is its gross fair market value (i.e., fair market 
value determined without regard to mortgages, liens, pledges, or other 
liabilities). However, for purposes of determining the amount of old 
target's deemed sale tax consequences, the fair market value of any 
property subject to a nonrecourse indebtedness will be treated as being

[[Page 121]]

not less than the amount of such indebtedness. (For purposes of the 
preceding sentence, a liability that was incurred because of the 
acquisition of the property is disregarded to the extent that such 
liability was not taken into account in determining old target's basis 
in such property.)
    (ii) Transaction costs. Transaction costs are not taken into account 
in allocating ADSP or AGUB to assets in the deemed sale (except 
indirectly through their effect on the total ADSP or AGUB to be 
allocated).
    (iii) Internal Revenue Service authority. In connection with the 
examination of a return, the Internal Revenue Service may challenge the 
taxpayer's determination of the fair market value of any asset by any 
appropriate method and take into account all factors, including any lack 
of adverse tax interests between the parties.
    (b) General rule for allocating ADSP and AGUB--(1) Reduction in the 
amount of consideration for Class I assets. Both ADSP and AGUB, in the 
respective allocation of each, are first reduced by the amount of Class 
I assets. Class I assets are cash and general deposit accounts 
(including savings and checking accounts) other than certificates of 
deposit held in banks, savings and loan associations, and other 
depository institutions. If the amount of Class I assets exceeds AGUB, 
new target will immediately realize ordinary income in an amount equal 
to such excess. The amount of ADSP or AGUB remaining after the reduction 
is to be allocated to the remaining acquisition date assets.
    (2) Other assets--(i) In general. Subject to the limitations and 
other rules of paragraph (c) of this section, ADSP and AGUB (as reduced 
by the amount of Class I assets) are allocated among Class II 
acquisition date assets of target in proportion to the fair market 
values of such Class II assets at such time, then among Class III assets 
so held in such proportion, then among Class IV assets so held in such 
proportion, then among Class V assets so held in such proportion, then 
among Class VI assets so held in such proportion, and finally to Class 
VII assets. If an asset is described below as includible in more than 
one class, then it is included in such class with the lower or lowest 
class number (for instance, Class III has a lower class number than 
Class IV).
    (ii) Class II assets. Class II assets are actively traded personal 
property within the meaning of section 1092(d)(1) and Sec. 1.1092(d)-1 
(determined without regard to section 1092(d)(3)). In addition, Class II 
assets include certificates of deposit and foreign currency even if they 
are not actively traded personal property. Class II assets do not 
include stock of target affiliates, whether or not of a class that is 
actively traded, other than actively traded stock described in section 
1504(a)(4). Examples of Class II assets include U.S. government 
securities and publicly traded stock.
    (iii) Class III assets. Class III assets are assets that the 
taxpayer marks to market at least annually for Federal income tax 
purposes and debt instruments (including accounts receivable). However, 
Class III assets do not include--
    (A) Debt instruments issued by persons related at the beginning of 
the day following the acquisition date to the target under section 
267(b) or 707;
    (B) Contingent debt instruments subject to Sec. 1.1275-4, Sec. 
1.483-4, or section 988, unless the instrument is subject to the non-
contingent bond method of Sec. 1.1275-4(b) or is described in Sec. 
1.988-2(b)(2)(i)(B)(2); and
    (C) Debt instruments convertible into the stock of the issuer or 
other property.
    (iv) Class IV assets. Class IV assets are stock in trade of the 
taxpayer or other property of a kind that would properly be included in 
the inventory of taxpayer if on hand at the close of the taxable year, 
or property held by the taxpayer primarily for sale to customers in the 
ordinary course of its trade or business.
    (v) Class V assets. Class V assets are all assets other than Class 
I, II, III, IV, VI, and VII assets.
    (vi) Class VI assets. Class VI assets are all section 197 
intangibles, as defined in section 197, except goodwill and going 
concern value.
    (vii) Class VII assets. Class VII assets are goodwill and going 
concern value (whether or not the goodwill or going concern value 
qualifies as a section 197 intangible).

[[Page 122]]

    (3) Other items designated by the Internal Revenue Service. Similar 
items may be added to any class described in this paragraph (b) by 
designation in the Internal Revenue Bulletin by the Internal Revenue 
Service (see Sec. 601.601(d)(2) of this chapter).
    (c) Certain limitations and other rules for allocation to an asset--
(1) Allocation not to exceed fair market value. The amount of ADSP or 
AGUB allocated to an asset (other than Class VII assets) cannot exceed 
the fair market value of that asset at the beginning of the day after 
the acquisition date.
    (2) Allocation subject to other rules. The amount of ADSP or AGUB 
allocated to an asset is subject to other provisions of the Internal 
Revenue Code or general principles of tax law in the same manner as if 
such asset were transferred to or acquired from an unrelated person in a 
sale or exchange. For example, if the deemed asset sale is a transaction 
described in section 1056(a) (relating to basis limitation for player 
contracts transferred in connection with the sale of a franchise), the 
amount of AGUB allocated to a contract for the services of an athlete 
cannot exceed the limitation imposed by that section. As another 
example, section 197(f)(5) applies in determining the amount of AGUB 
allocated to an amortizable section 197 intangible resulting from an 
assumption-reinsurance transaction.
    (3) Special rule for allocating AGUB when purchasing corporation has 
nonrecently purchased stock--(i) Scope. This paragraph (c)(3) applies if 
at the beginning of the day after the acquisition date--
    (A) The purchasing corporation holds nonrecently purchased stock for 
which a gain recognition election under section 338(b)(3) and Sec. 
1.338-5(d) is not made; and
    (B) The hypothetical purchase price determined under paragraph 
(c)(3)(ii) of this section exceeds the AGUB determined under Sec. 
1.338-5(b).
    (ii) Determination of hypothetical purchase price. Hypothetical 
purchase price is the AGUB that would result if a gain recognition 
election were made.
    (iii) Allocation of AGUB. Subject to the limitations in paragraphs 
(c)(1) and (2) of this section, the portion of AGUB (after reduction by 
the amount of Class I assets) to be allocated to each Class II, III, IV, 
V, VI, and VII asset of target held at the beginning of the day after 
the acquisition date is determined by multiplying--
    (A) The amount that would be allocated to such asset under the 
general rules of this section were AGUB equal to the hypothetical 
purchase price; by
    (B) A fraction, the numerator of which is actual AGUB (after 
reduction by the amount of Class I assets) and the denominator of which 
is the hypothetical purchase price (after reduction by the amount of 
Class I assets).
    (4) Liabilities taken into account in determining amount realized on 
subsequent disposition. In determining the amount realized on a 
subsequent sale or other disposition of property deemed purchased by new 
target, Sec. 1.1001-2(a)(3) shall not apply to any liability that was 
taken into account in AGUB.
    (5) Allocation to certain nuclear decommissioning funds--(i) General 
rule. For purposes of allocating ADSP or AGUB among the acquisition date 
assets of a target (and for no other purpose), a taxpayer may elect to 
treat a nonqualified nuclear decommissioning fund (as defined in 
paragraph (c)(5)(ii) of this section) of the target as if--
    (A) Such fund were an entity classified as a corporation;
    (B) The stock of the corporation were among the acquisition date 
assets of the target and a Class V asset;
    (C) The corporation owned the assets of the fund;
    (D) The corporation bore the responsibility for decommissioning one 
or more nuclear power plants to the extent assets of the fund are 
expected to be used for that purpose; and
    (E) A section 338(h)(10) election were made for the corporation 
(regardless of whether the requirements for a section 338(h)(10) 
election are otherwise satisfied).
    (ii) Definition of nonqualified nuclear decommissioning fund. A 
nonqualified nuclear decommissioning fund means a trust, escrow account, 
Government fund or other type of agreement--
    (A) That is established in writing by the owner or licensee of a 
nuclear generating unit for the exclusive purpose

[[Page 123]]

of funding the decommissioning of one or more nuclear power plants;
    (B) That is described to the Nuclear Regulatory Commission in a 
report described in 10 CFR 50.75(b) as providing assurance that funds 
will be available for decommissioning;
    (C) That is not a Nuclear Decommissioning Reserve Fund, as described 
in section 468A;
    (D) That is maintained at all times in the United States; and
    (E) The assets of which are to be used only as permitted by 10 CFR 
50.82(a)(8).
    (iii) Availability of election. P may make the election described in 
this paragraph (c)(5) regardless of whether the selling consolidated 
group (or the selling affiliate or the S corporation shareholders) also 
makes the election. In addition, the selling consolidated group (or the 
selling affiliate or the S corporation shareholders) may make the 
election regardless of whether P also makes the election. If T is an S 
corporation, all of the S corporation shareholders, including those that 
do not sell their stock, must consent to the election for the election 
to be effective as to any S corporation shareholder.
    (iv) Time and manner of making election. The election described in 
this paragraph (c)(5) is made by taking a position on an original or 
amended tax return for the taxable year of the qualified stock purchase 
that is consistent with having made the election. Such tax return must 
be filed no later than the later of 30 days after the date on which the 
section 338 election is due or the day the original tax return for the 
taxable year of the qualified stock purchase is due (with extensions).
    (v) Irrevocability of election. An election made pursuant to this 
paragraph (c)(5) is irrevocable.
    (vi) Effective/applicability date. This paragraph (c)(5) applies to 
qualified stock purchases occurring on or after September 11, 2007. For 
qualified stock purchases occurring before September 11, 2007 and on or 
after September 15, 2004, see Sec. 1.338-6T as contained in 26 CFR part 
1 in effect on April 1, 2007. For qualified stock purchases occurring 
before September 15, 2004, see Sec. 1.338-6 as contained in 26 CFR part 
1 in effect on April 1, 2004.
    (d) Examples. The following examples illustrate Sec. Sec. 1.338-4, 
1.338-5, and this section:

    Example 1. (i) T owns 90 percent of the outstanding T1 stock. P 
purchases 100 percent of the outstanding T stock for $2,000. There are 
no acquisition costs. P makes a section 338 election for T and, as a 
result, T1 is considered acquired in a qualified stock purchase. A 
section 338 election is made for T1. The grossed-up basis of the T stock 
is $2,000 (i.e., $2,000 + 1/1).
    (ii) The liabilities of T as of the beginning of the day after the 
acquisition date (including the tax liability for the deemed sale tax 
consequences) that would, under general principles of tax law, properly 
be taken into account at that time, are as follows:

Liabilities (nonrecourse mortgage plus unsecured liabilities)..     $700
Taxes Payable..................................................      300
                                                                --------
    Total......................................................    1,000
 

    (iii) The AGUB of T is determined as follows:

Grossed-up basis...............................................   $2,000
Total liabilities..............................................    1,000
                                                                --------
    AGUB.......................................................    3,000
 

    (iv) Assume that ADSP is also $3,000.
    (v) Assume that, at the beginning of the day after the acquisition 
date, T's cash and the fair market values of T's Class II, III, IV, and 
V assets are as follows:

------------------------------------------------------------------------
                                                                   Fair
         Asset class                        Asset                 market
                                                                  value
------------------------------------------------------------------------
I...........................  Cash.............................   * $200
II..........................  Portfolio of actively traded           300
                               securities.
III.........................  Accounts receivable..............      600
IV..........................  Inventory........................      300
V...........................  Building.........................      800
V...........................  Land.............................      200
V...........................  Investment in T1.................      450
                                                                --------
                               Total...........................   2,850
------------------------------------------------------------------------
*Amount.

    (vi) Under paragraph (b)(1) of this section, the amount of ADSP and 
AGUB allocable to T's Class II, III, IV, and V assets is reduced by the 
amount of cash to $2,800, i.e., $3,000--$200. $300 of ADSP and of AGUB 
is then allocated to actively traded securities. $600 of ADSP and of 
AGUB is then allocated to accounts receivable. $300 of ADSP and of AGUB 
is then allocated to the inventory. Since the remaining amount of ADSP 
and of AGUB is $1,600 (i.e., $3,000--($200 + $300 + $600 + $300)), an 
amount which exceeds the sum of the fair market values of T's Class V 
assets, the amount of ADSP and of AGUB allocated to each Class V asset 
is its fair market value:

Building.......................................................     $800
Land...........................................................      200

[[Page 124]]

 
Investment in T1...............................................      450
                                                                --------
    Total......................................................    1,450
 

    (vii) T has no Class VI assets. The amount of ADSP and of AGUB 
allocated to T's Class VII assets (goodwill and going concern value) is 
$150, i.e., $1,600-$1,450.
    (viii) The grossed-up basis of the T1 stock is $500, i.e., $450 x 
1/.9.
    (ix) The liabilities of T1 as of the beginning of the day after the 
acquisition date (including the tax liability for the deemed sale tax 
consequences) that would, under general principles of tax law, properly 
be taken into account at that time, are as follows:

General Liabilities.............................................    $100
Taxes Payable...................................................      20
                                                                 -------
    Total.......................................................     120
 

    (x) The AGUB of T1 is determined as follows:

Grossed-up basis of T1 Stock....................................   $ 500
Liabilities.....................................................     120
                                                                 -------
    AGUB........................................................     620
 

    (xi) Assume that ADSP is also $620.
    (xii) Assume that at the beginning of the day after the acquisition 
date, T1's cash and the fair market values of its Class IV and VI assets 
are as follows:

------------------------------------------------------------------------
                                                                   Fair
         Asset class                        Asset                 market
                                                                  value
------------------------------------------------------------------------
I...........................  Cash.............................     *$50
IV..........................  Inventory........................      200
VI..........................  Patent...........................      350
                                                                --------
                               Total...........................     600
------------------------------------------------------------------------
* Amount.

    (xiii) The amount of ADSP and of AGUB allocable to T1's Class IV and 
VI assets is first reduced by the $50 of cash.
    (xiv) Because the remaining amount of ADSP and of AGUB ($570) is an 
amount which exceeds the fair market value of T1's only Class IV asset, 
the inventory, the amount allocated to the inventory is its fair market 
value ($200). After that, the remaining amount of ADSP and of AGUB 
($370) exceeds the fair market value of T1's only Class VI asset, the 
patent. Thus, the amount of ADSP and of AGUB allocated to the patent is 
its fair market value ($350).
    (xv) The amount of ADSP and of AGUB allocated to T1's Class VII 
assets (goodwill and going concern value) is $20, i.e., $570-$550.
    Example 2. (i) Assume that the facts are the same as in Example 1 
except that P has, for five years, owned 20 percent of T's stock, which 
has a basis in P's hands at the beginning of the day after the 
acquisition date of $100, and P purchases the remaining 80 percent of 
T's stock for $1,600. P does not make a gain recognition election under 
section 338(b)(3).
    (ii) Under Sec. 1.338-5(c), the grossed-up basis of recently 
purchased T stock is $1,600, i.e., $1,600 x (1-.2)/.8.
    (iii) The AGUB of T is determined as follows:

Grossed-up basis of recently purchased stock as determined        $1,600
 under Sec.  1.338-5(c) ($1,600 x (1-.2)/.8)..................
Basis of nonrecently purchased stock...........................      100
Liabilities....................................................    1,000
                                                                --------
    AGUB.......................................................    2,700
 

    (iv) Since P holds nonrecently purchased stock, the hypothetical 
purchase price of the T stock must be computed and is determined as 
follows:

Grossed-up basis of recently purchased stock as determined        $1,600
 under Sec.  1.338-5(c) ($1,600 x (1-.2)/.8)..................
Basis of nonrecently purchased stock as if the gain recognition      400
 election under Sec.  1.338-5(d)(2) had been made ($1,600 x .2/
 (1-.2)).......................................................
Liabilities....................................................    1,000
                                                                --------
    Total......................................................    3,000
 

    (v) Since the hypothetical purchase price ($3,000) exceeds the AGUB 
($2,700) and no gain recognition election is made under section 
338(b)(3), AGUB is allocated under paragraph (c)(3) of this section.
    (vi) First, an AGUB amount equal to the hypothetical purchase price 
($3,000) is allocated among the assets under the general rules of this 
section. The allocation is set forth in the column below entitled 
Original Allocation. Next, the allocation to each asset in Class II 
through Class VII is multiplied by a fraction having a numerator equal 
to the actual AGUB reduced by the amount of Class I assets ($2,700-$200 
= $2,500) and a denominator equal to the hypothetical purchase price 
reduced by the amount of Class I assets ($3,000-$200 = $2,800), or 
2,500/2,800. This produces the Final Allocation:

------------------------------------------------------------------------
                                                   Original      Final
        Class                    Asset            allocation  allocation
------------------------------------------------------------------------
I....................  Cash.....................        $200        $200
II...................  Portfolio of actively             300        *268
                        traded securities.
III..................  Accounts receivable......         600         536
IV...................  Inventory................         300         268
V....................  Building.................         800         714
V....................  Land.....................         200         178
V....................  Investment in T1.........         450         402
VII..................  Goodwill and going                150         134
                        concern value.
                                                 -----------------------
                        Total...................       3,000      2,700
------------------------------------------------------------------------
* All numbers rounded for convenience.


[T.D. 8940, 66 FR 9929, Feb. 13, 2001; 66 FR 17363, Mar. 30, 2001; T.D. 
9158, 69 FR 55742, Sept. 16, 2004; T.D. 9358, 72 FR 51706, Sept. 11, 
2007]

[[Page 125]]



Sec. 1.338-7  Allocation of redetermined ADSP and AGUB among target assets.

    (a) Scope. ADSP and AGUB are redetermined at such time and in such 
amount as an increase or decrease would be required under general 
principles of tax law for the elements of ADSP or AGUB. This section 
provides rules for allocating redetermined ADSP or AGUB.
    (b) Allocation of redetermined ADSP and AGUB. When ADSP or AGUB is 
redetermined, a new allocation of ADSP or AGUB is made by allocating the 
redetermined ADSP or AGUB amount under the rules of Sec. 1.338-6. If 
the allocation of the redetermined ADSP or AGUB amount under Sec. 
1.338-6 to a given asset is different from the original allocation to 
it, the difference is added to or subtracted from the original 
allocation to the asset, as appropriate. (See paragraph (d) of this 
section for new target's treatment of the amount so allocated.) Amounts 
allocable to an acquisition date asset (or with respect to a disposed-of 
acquisition date asset) are subject to all the asset allocation rules 
(for example, the fair market value limitation in Sec. 1.338-6(c)(1)) 
as if the redetermined ADSP or AGUB were the ADSP or AGUB on the 
acquisition date.
    (c) Special rules for ADSP--(1) Increases or decreases in deemed 
sale tax consequences taxable notwithstanding old target ceases to 
exist. To the extent general principles of tax law would require a 
seller in an actual asset sale to account for events relating to the 
sale that occur after the sale date, target must make such an 
accounting. Target is not precluded from realizing additional deemed 
sale tax consequences because the target is treated as a new corporation 
after the acquisition date.
    (2) Procedure for transactions in which section 338(h)(10) is not 
elected--(i) Deemed sale tax consequences included in new target's 
return. If an election under section 338(h)(10) is not made, any 
additional deemed sale tax consequences of old target resulting from an 
increase or decrease in the ADSP are included in new target's income tax 
return for new target's taxable year in which the increase or decrease 
is taken into account. For example, if after the acquisition date there 
is an increase in the allocable ADSP of section 1245 property for which 
the recomputed basis (but not the adjusted basis) exceeds the portion of 
the ADSP allocable to that particular asset on the acquisition date, the 
additional gain is treated as ordinary income to the extent it does not 
exceed such excess amount. See paragraph (c)(2)(ii) of this section for 
the special treatment of old target's carryovers and carrybacks. 
Although included in new target's income tax return, the deemed sale tax 
consequences are separately accounted for as an item of old target and 
may not be offset by income, gain, deduction, loss, credit, or other 
amount of new target. The amount of tax on income of old target 
resulting from an increase or decrease in the ADSP is determined as if 
such deemed sale tax consequences had been recognized in old target's 
taxable year ending at the close of the acquisition date. However, 
because the income resulting from the increase or decrease in ADSP is 
reportable in new target's taxable year of the increase or decrease, not 
in old target's taxable year ending at the close of the acquisition 
date, there is not a resulting underpayment of tax in that past taxable 
year of old target for purposes of calculation of interest due.
    (ii) Carryovers and carrybacks--(A) Loss carryovers to new target 
taxable years. A net operating loss or net capital loss of old target 
may be carried forward to a taxable year of new target, under the 
principles of section 172 or 1212, as applicable, but is allowed as a 
deduction only to the extent of any recognized income of old target for 
such taxable year, as described in paragraph (c)(2)(i) of this section. 
For this purpose, however, taxable years of new target are not taken 
into account in applying the limitations in section 172(b)(1) or 
1212(a)(1)(B) (or other similar limitations). In applying sections 
172(b) and 1212(a)(1), only income, gain, loss, deduction, credit, and 
other amounts of old target are taken into account. Thus, if old target 
has an unexpired net operating loss at the close of its taxable year in 
which the deemed asset sale occurred that could be carried forward to a 
subsequent taxable year, such loss may be carried forward

[[Page 126]]

until it is absorbed by old target's income.
    (B) Loss carrybacks to taxable years of old target. An ordinary loss 
or capital loss accounted for as a separate item of old target under 
paragraph (c)(2)(i) of this section may be carried back to a taxable 
year of old target under the principles of section 172 or 1212, as 
applicable. For this purpose, taxable years of new target are not taken 
into account in applying the limitations in section 172(b) or 1212(a) 
(or other similar limitations).
    (C) Credit carryovers and carrybacks. The principles described in 
paragraphs (c)(2)(ii)(A) and (B) of this section apply to carryovers and 
carrybacks of amounts for purposes of determining the amount of a credit 
allowable under part IV, subchapter A, chapter 1 of the Internal Revenue 
Code. Thus, for example, credit carryovers of old target may offset only 
income tax attributable to items described in paragraph (c)(2)(i) of 
this section.
    (3) Procedure for transactions in which section 338(h)(10) is 
elected. If an election under section 338(h)(10) is made, any changes in 
the deemed sale tax consequences caused by an increase or decrease in 
the ADSP are accounted for in determining the taxable income (or other 
amount) of the member of the selling consolidated group, the selling 
affiliate, or the S corporation shareholders to which such income, loss, 
or other amount is attributable for the taxable year in which such 
increase or decrease is taken into account.
    (d) Special rules for AGUB--(1) Effect of disposition or 
depreciation of acquisition date assets. If an acquisition date asset 
has been disposed of, depreciated, amortized, or depleted by new target 
before an amount is added to the original allocation to the asset, the 
increased amount otherwise allocable to such asset is taken into account 
under general principles of tax law that apply when part of the cost of 
an asset not previously taken into account in basis is paid or incurred 
after the asset has been disposed of, depreciated, amortized, or 
depleted. A similar rule applies when an amount is subtracted from the 
original allocation to the asset. For purposes of the preceding 
sentence, an asset is considered to have been disposed of to the extent 
that its allocable portion of the decrease in AGUB would reduce its 
basis below zero.
    (2) Section 38 property. Section 1.47-2(c) applies to a reduction in 
basis of section 38 property under this section.
    (e) Examples. The following examples illustrate this section. Any 
amount described in the following examples is exclusive of interest. For 
rules characterizing deferred contingent payments as principal or 
interest, see Sec. Sec. 1.483-4, 1.1274-2(g), and 1.1275-4(c). The 
examples are as follows:

    Example 1. (i)(A) T's assets other than goodwill and going concern 
value, and their fair market values at the beginning of the day after 
the acquisition date, are as follows:

------------------------------------------------------------------------
                                                                  Fair
         Asset class                        Asset                market
                                                                  value
------------------------------------------------------------------------
V...........................  Building........................     $ 100
V...........................  Stock of X (not a target).......       200
                                                               ---------
                               Total..........................       300
------------------------------------------------------------------------

    (B) T has no liabilities other than a contingent liability that 
would not be taken into account under general principles of tax law in 
an asset sale between unrelated parties when the buyer assumed the 
liability or took property subject to it.
    (ii)(A) On September 1, 2000, P purchases all of the outstanding 
stock of T for $270 and makes a section 338 election for T. The grossed-
up basis of the T stock and T's AGUB are both $270. The AGUB is ratably 
allocated among T's Class V assets in proportion to their fair market 
values as follows:

------------------------------------------------------------------------
                              Asset                                Basis
------------------------------------------------------------------------
Building ($270 x 100/300).......................................     $90
Stock ($270 x 200/300)..........................................     180
                                                                 -------
    Total.......................................................     270
------------------------------------------------------------------------

    (B) No amount is allocated to the Class VII assets. New T is a 
calendar year taxpayer. Assume that the X stock is a capital asset in 
the hands of new T.
    (iii) On January 1, 2001, new T sells the X stock and uses the 
proceeds to purchase inventory.
    (iv) Pursuant to events on June 30, 2002, the contingent liability 
of old T is at that time properly taken into account under general 
principles of tax law. The amount of the liability is $60.
    (v) T's AGUB increases by $60 from $270 to $330. This $60 increase 
in AGUB is first allocated among T's acquisition date assets in 
accordance with the provisions of Sec. 1.338-6. Because the 
redetermined AGUB for T ($330)

[[Page 127]]

exceeds the sum of the fair market values at the beginning of the day 
after the acquisition date of the Class V acquisition date assets 
($300), AGUB allocated to those assets is limited to those fair market 
values under Sec. 1.338-6(c)(1). As there are no Class VI assets, the 
remaining AGUB of $30 is allocated to goodwill and going concern value 
(Class VII assets). The amount of increase in AGUB allocated to each 
acquisition date asset is determined as follows:

------------------------------------------------------------------------
                                        Original  Redetermined
                 Asset                    AGUB        AGUB      Increase
------------------------------------------------------------------------
Building..............................       $90        $100         $10
X Stock...............................       180         200          20
Goodwill and going concern value......         0          30          30
                                       ---------------------------------
    Total.............................       270         330          60
------------------------------------------------------------------------

    (vi) Since the X stock was disposed of before the contingent 
liability was properly taken into account for tax purposes, no amount of 
the increase in AGUB attributable to such stock may be allocated to any 
T asset. Rather, such amount ($20) is allowed as a capital loss to T for 
the taxable year 2002 under the principles of Arrowsmith v. 
Commissioner, 344 U.S. 6 (1952). In addition, the $10 increase in AGUB 
allocated to the building and the $30 increase in AGUB allocated to the 
goodwill and going concern value are treated as basis redeterminations 
in 2002. See paragraph (d)(1) of this section.
    Example 2. (i) On January 1, 2002, P purchases all of the 
outstanding stock of T and makes a section 338 election for T. Assume 
that ADSP and AGUB of T are both $500 and are allocated among T's 
acquisition date assets as follows:

------------------------------------------------------------------------
         Asset Class                        Asset                 Basis
------------------------------------------------------------------------
V...........................  Machinery........................     $150
V...........................  Land.............................      250
VII.........................  Goodwill and going concern value.      100
                                                                --------
                               Total...........................      500
------------------------------------------------------------------------

    (ii) On September 30, 2004, P filed a claim against the selling 
shareholders of T in a court of appropriate jurisdiction alleging fraud 
in the sale of the T stock.
    (iii) On January 1, 2007, the former shareholders refund $140 of the 
purchase price to P in a settlement of the lawsuit. Assume that, under 
general principles of tax law, both the seller and the buyer properly 
take into account such refund when paid. Assume also that the refund has 
no effect on the tax liability for the deemed sale tax consequences. 
This refund results in a decrease of T's ADSP and AGUB of $140, from 
$500 to $360.
    (iv) The redetermined ADSP and AGUB of $360 is allocated among T's 
acquisition date assets. Because ADSP and AGUB do not exceed the fair 
market value of the Class V assets, the ADSP and AGUB amounts are 
allocated to the Class V assets in proportion to their fair market 
values at the beginning of the day after the acquisition date. Thus, 
$135 ($150 x ($360/($150 + $250))) is allocated to the machinery and 
$225 ($250 x ($360/($150 + $250))) is allocated to the land. 
Accordingly, the basis of the machinery is reduced by $15 ($150 original 
allocation--$135 redetermined allocation) and the basis of the land is 
reduced by $25 ($250 original allocation--$225 redetermined allocation). 
No amount is allocated to the Class VII assets. Accordingly, the basis 
of the goodwill and going concern value is reduced by $100 ($100 
original allocation--$0 redetermined allocation).
    (v) Assume that, as a result of deductions under section 168, the 
adjusted basis of the machinery immediately before the decrease in AGUB 
is zero. The machinery is treated as if it were disposed of before the 
decrease is taken into account. In 2007, T recognizes income of $15, the 
character of which is determined under the principles of Arrowsmith v. 
Commissioner and the tax benefit rule. No adjustment to the basis of T's 
assets is made for any tax paid on this amount. Assume also that, as a 
result of amortization deductions, the adjusted basis of the goodwill 
and going concern value immediately before the decrease in AGUB is $40. 
A similar adjustment to income is made in 2007 with respect to the $60 
of previously amortized goodwill and going concern value.
    (vi) In summary, the basis of T's acquisition date assets, as of 
January 1, 2007, is as follows:

------------------------------------------------------------------------
                             Asset                                Basis
------------------------------------------------------------------------
Machinery......................................................       $0
Land...........................................................      225
Goodwill and going concern value...............................        0
------------------------------------------------------------------------

    Example 3. (i) Assume that the facts are the same as Sec. 1.338-
6(d) Example 2 except that the recently purchased stock is acquired for 
$1,600 plus additional payments that are contingent upon T's future 
earnings. Assume that, under general principles of tax law, such later 
payments are properly taken into account when paid. Thus, T's AGUB, 
determined as of the beginning of the day after the acquisition date 
(after reduction by T's cash of $200), is $2,500 and is allocated among 
T's acquisition date assets under Sec. 1.338-6(c)(3)(iii) as follows:

------------------------------------------------------------------------
                                                                 Final
           Class                          Asset               allocation
------------------------------------------------------------------------
I..........................  Cash...........................        $200
II.........................  Portfolio of actively traded           *268
                              securities.
III........................  Accounts receivable............         536
IV.........................  Inventory......................         268
V..........................  Building.......................         714
V..........................  Land...........................         178

[[Page 128]]

 
V..........................  Investment in T1...............         402
VII........................  Goodwill and going concern              134
                              value.
 
------------------------------------------------------------------------
* All numbers rounded for convenience.

    (ii) At a later point in time, P pays an additional $200 for its 
recently purchased T stock. Assume that the additional consideration 
paid would not increase T's tax liability for the deemed sale tax 
consequences.
    (iii) T's AGUB increases by $200, from $2,700 to $2,900. This $200 
increase in AGUB is accounted for in accordance with the provisions of 
Sec. 1.338-6(c)(3)(iii).
    (iv) The hypothetical purchase price of the T stock is redetermined 
as follows:

Grossed-up basis of recently purchased stock as determined        $1,800
 under Sec.  1.338-5(c) ($1,800 x (1- .2)/.8).................
Basis of nonrecently purchased stock as if the gain recognition      450
 election under Sec.  1.338-5(d)(2) had been made ($1,800 x .2/
 (1- .2))......................................................
Liabilities....................................................    1,000
                                                                --------
    Total......................................................    3,250
 

    (v) Since the redetermined hypothetical purchase price ($3,250) 
exceeds the redetermined AGUB ($2,900) and no gain recognition election 
was made under section 338(b)(3), the rules of Sec. 1.338-6(c)(3)(iii) 
are reapplied using the redetermined hypothetical purchase price and the 
redetermined AGUB.
    (vi) First, an AGUB amount equal to the redetermined hypothetical 
purchase price ($3,250) is allocated among the assets under the general 
rules of Sec. 1.338-6. The allocation is set forth in the column below 
entitled Hypothetical Allocation. Next, the allocation to each asset in 
Class II through Class VII is multiplied by a fraction with a numerator 
equal to the actual redetermined AGUB reduced by the amount of Class I 
assets ($2,900 - $200 = $2,700) and a denominator equal to the 
redetermined hypothetical purchase price reduced by the amount of Class 
I assets ($3,250 - $200 = $3,050), or 2,700/3,050. This produces the 
Final Allocation:

------------------------------------------------------------------------
                                                Hypothetical     Final
        Class                   Asset            allocation   allocation
------------------------------------------------------------------------
I...................  Cash....................         $200         $200
II..................  Portfolio of actively             300         *266
                       traded securities.
III.................  Accounts receivable.....          600          531
IV..................  Inventory...............          300          266
V...................  Building................          800          708
V...................  Land....................          200          177
V...................  Investment in T1........          450          398
VII.................  Goodwill and going                400          354
                       concern value.
                                               -------------------------
                       Total..................        3,250        2900
------------------------------------------------------------------------
* All numbers rounded for convenience.

    (vii) As illustrated by this example, reapplying Sec. 1.338-6(c)(3) 
results in a basis increase for some assets and a basis decrease for 
other assets. The amount of redetermined AGUB allocated to each 
acquisition date asset is determined as follows:

------------------------------------------------------------------------
                                     Original   Redetermined
               Asset                  (c)(3)       (c)(3)      Increase
                                    allocation   allocation   (decrease)
------------------------------------------------------------------------
Portfolio of actively traded              $268         $266         $(2)
 securities.......................
Accounts receivable...............         536          531          (5)
Inventory.........................         268          266          (2)
Building..........................         714          708          (6)
Land..............................         178          177          (1)
Investment in T1..................         402          398          (4)
Goodwill and going concern value..         134          354          220
                                   -------------------------------------
    Total.........................       2,500        2,700          200
------------------------------------------------------------------------

    Example 4. (i) On January 1, 2001, P purchases all of the 
outstanding T stock and makes a section 338 election for T. P pays $700 
of cash and promises also to pay a maximum $300 of contingent 
consideration at various times in the future. Assume that, under general 
principles of tax law, such later payments are properly taken into 
account by P when paid. Assume also, however, that the current fair 
market value of the contingent payments is reasonably ascertainable. The 
fair market value of T's assets (other than goodwill and going concern 
value) as of the beginning of the following day is as follows:

------------------------------------------------------------------------
                                                                  Fair
        Asset class                       Assets                 market
                                                                 value
------------------------------------------------------------------------
V..........................  Equipment.......................       $200
V..........................  Non-actively traded securities..        100
V..........................  Building........................        500
                                                              ----------
                              Total..........................        800
------------------------------------------------------------------------

    (ii) T has no liabilities. The AGUB is $700. In calculating ADSP, 
assume that, under Sec. 1.1001-1, the current amount realized 
attributable to the contingent consideration is $200. ADSP is therefore 
$900 ($700 cash plus $200).

[[Page 129]]

    (iii) (A) The AGUB of $700 is ratably allocated among T's Class V 
acquisition date assets in proportion to their fair market values as 
follows:

------------------------------------------------------------------------
                            Asset                                Basis
------------------------------------------------------------------------
Equipment ($700 x 200/800)...................................    $175.00
Non-actively traded securities ($700 x 100/800)..............      87.50
Building ($700 x 500/800)....................................     437.50
                                                              ----------
    Total....................................................     700.00
------------------------------------------------------------------------

    (B) No amount is allocated to goodwill or going concern value.
    (iv) (A) The ADSP of $900 is ratably allocated among T's Class V 
acquisition date assets in proportion to their fair market values as 
follows:

------------------------------------------------------------------------
                            Asset                                Basis
------------------------------------------------------------------------
Equipment....................................................       $200
Non-actively traded securities...............................        100
Building.....................................................        500
                                                              ----------
    Total....................................................        800
------------------------------------------------------------------------

    (B) The remaining ADSP, $100, is allocated to goodwill and going 
concern value (Class VII).
    (v) P and T file a consolidated return for 2001 and each following 
year with P as the common parent of the affiliated group.
    (vi) In 2004, a contingent amount of $120 is paid by P. For old T, 
this payment has no effect on ADSP, because the payment is accounted for 
as a separate transaction. We have assumed that, under general 
principles of tax law, the payment is properly taken into account by P 
at the time made. Therefore, in 2004, there is an increase in new T's 
AGUB of $120. The amount of the increase allocated to each acquisition 
date asset is determined as follows:

------------------------------------------------------------------------
                                       Original  Redetermined
                Asset                    AGUB        AGUB       Increase
------------------------------------------------------------------------
Equipment...........................    $175.00      $200.00      $25.00
Land................................      87.50       100.00       12.50
Building............................     437.50       500.00       62.50
Goodwill and going concern value....       0.00        20.00       20.00
                                     -----------------------------------
    Total...........................     700.00       820.00      120.00
------------------------------------------------------------------------


[T.D. 8940, 66 FR 9929, Feb. 13, 2001]



Sec. 1.338-8  Asset and stock consistency.

    (a) Introduction--(1) Overview. This section implements the 
consistency rules of sections 338(e) and (f). Under this section, no 
election under section 338 is deemed made or required with respect to 
target or any target affiliate. Instead, the person acquiring an asset 
may have a carryover basis in the asset.
    (2) General application. The consistency rules generally apply if 
the purchasing corporation acquires an asset directly from target during 
the target consistency period and target is a subsidiary in a 
consolidated group. In such a case, gain from the sale of the asset is 
reflected under the investment adjustment provisions of the consolidated 
return regulations in the basis of target stock and may reduce gain from 
the sale of the stock. See Sec. 1.1502-32 (investment adjustment 
provisions). Under the consistency rules, the purchasing corporation 
generally takes a carryover basis in the asset, unless a section 338 
election is made for target. Similar rules apply if the purchasing 
corporation acquires an asset directly from a lower-tier target 
affiliate if gain from the sale is reflected under the investment 
adjustment provisions in the basis of target stock.
    (3) Extensions of the general rules. If an arrangement exists, 
paragraph (f) of this section generally extends the carryover basis rule 
to certain cases in which the purchasing corporation acquires assets 
indirectly from target (or a lower-tier target affiliate). To prevent 
avoidance of the consistency rules, paragraph (j) of this section also 
may extend the consistency period or the 12-month acquisition period and 
may disregard the presence of conduits.
    (4) Application where certain dividends are paid. Paragraph (g) of 
this section extends the carryover basis rule to certain cases in which 
dividends are paid to a corporation that is not a member of the same 
consolidated group as the distributing corporation. Generally, this rule 
applies where a 100 percent dividends received deduction is used in 
conjunction with asset dispositions to achieve an effect similar to that 
available under the investment adjustment provisions of the consolidated 
return regulations.
    (5) Application to foreign target affiliates. Paragraph (h) of this 
section extends the carryover basis rule to certain cases involving 
target affiliates that are controlled foreign corporations.

[[Page 130]]

    (6) Stock consistency. This section limits the application of the 
stock consistency rules to cases in which the rules are necessary to 
prevent avoidance of the asset consistency rules. Following the general 
treatment of a section 338(h)(10) election, a sale of a corporation's 
stock is treated as a sale of the corporation's assets if a section 
338(h)(10) election is made. Because gain from this asset sale may be 
reflected in the basis of the stock of a higher-tier target, the 
carryover basis rule may apply to the assets.
    (b) Consistency for direct acquisitions--(1) General rule. The basis 
rules of paragraph (d) of this section apply to an asset if--
    (i) The asset is disposed of during the target consistency period;
    (ii) The basis of target stock, as of the target acquisition date, 
reflects gain from the disposition of the asset (see paragraph (c) of 
this section); and
    (iii) The asset is owned, immediately after its acquisition and on 
the target acquisition date, by a corporation that acquires stock of 
target in the qualified stock purchase (or by an affiliate of an 
acquiring corporation).
    (2) Section 338(h)(10) elections. For purposes of this section, if a 
section 338(h)(10) election is made for a corporation acquired in a 
qualified stock purchase--
    (i) The acquisition is treated as an acquisition of the 
corporation's assets (see Sec. 1.338(h)(10)-1); and
    (ii) The corporation is not treated as target.
    (c) Gain from disposition reflected in basis of target stock. For 
purposes of this section:
    (1) General rule. Gain from the disposition of an asset is reflected 
in the basis of a corporation's stock if the gain is taken into account 
under Sec. 1.1502-32, directly or indirectly, in determining the basis 
of the stock, after applying section 1503(e) and other provisions of the 
Internal Revenue Code.
    (2) Gain not reflected if section 338 election made for target. Gain 
from the disposition of an asset that is otherwise reflected in the 
basis of target stock as of the target acquisition date is not 
considered reflected in the basis of target stock if a section 338 
election is made for target.
    (3) Gain reflected by reason of distributions. Gain from the 
disposition of an asset is not considered reflected in the basis of 
target stock merely by reason of the receipt of a distribution from a 
target affiliate that is not a member of the same consolidated group as 
the distributee. See paragraph (g) of this section for the treatment of 
dividends eligible for a 100 percent dividends received deduction.
    (4) Controlled foreign corporations. For a limitation applicable to 
gain of a target affiliate that is a controlled foreign corporation, see 
paragraph (h)(2) of this section.
    (5) Gain recognized outside the consolidated group. Gain from the 
disposition of an asset by a person other than target or a target 
affiliate is not reflected in the basis of a corporation's stock unless 
the person is a conduit, as defined in paragraph (j)(4) of this section.
    (d) Basis of acquired assets--(1) Carryover basis rule. If this 
paragraph (d) applies to an asset, the asset's basis immediately after 
its acquisition is, for all purposes of the Internal Revenue Code, its 
adjusted basis immediately before its disposition.
    (2) Exceptions to carryover basis rule for certain assets. The 
carryover basis rule of paragraph (d)(1) of this section does not apply 
to the following assets--
    (i) Any asset disposed of in the ordinary course of a trade or 
business (see section 338(e)(2)(A));
    (ii) Any asset the basis of which is determined wholly by reference 
to the adjusted basis of the asset in the hands of the person that 
disposed of the asset (see section 338(e)(2)(B));
    (iii) Any debt or equity instrument issued by target or a target 
affiliate (see paragraph (h)(3) of this section for an exception 
relating to the stock of a target affiliate that is a controlled foreign 
corporation);
    (iv) Any asset the basis of which immediately after its acquisition 
would otherwise be less than its adjusted basis immediately before its 
disposition; and
    (v) Any asset identified by the Internal Revenue Service in a 
revenue ruling or revenue procedure.
    (3) Exception to carryover basis rule for de minimis assets. The 
carryover basis rules of this section do not apply to an

[[Page 131]]

asset if the asset is not disposed of as part of the same arrangement as 
the acquisition of target and the aggregate amount realized for all 
assets otherwise subject to the carryover basis rules of this section 
does not exceed $250,000.
    (4) Mitigation rule--(i) General rule. If the carryover basis rules 
of this section apply to an asset and the asset is transferred to a 
domestic corporation in a transaction to which section 351 applies or as 
a contribution to capital and no gain is recognized, the transferor's 
basis in the stock of the transferee (but not the transferee's basis in 
the asset) is determined without taking into account the carryover basis 
rules of this section.
    (ii) Time for transfer. This paragraph (d)(4) applies only if the 
asset is transferred before the due date (including extensions) for the 
transferor's income tax return for the year that includes the last date 
for which a section 338 election may be made for target.
    (e) Examples--(1) In general. For purposes of the examples in this 
section, unless otherwise stated, the basis of each asset is the same 
for determining earnings and profits and taxable income, the exceptions 
to paragraph (d)(1) of this section do not apply, the taxable year of 
all persons is the calendar year, and the following facts apply: S is 
the common parent of a consolidated group that includes T, T1, T2, and 
T3; S owns all of the stock of T and T3; and T owns all of the stock of 
T1, which owns all of the stock of T2. B is unrelated to the S group and 
owns all of the stock of P, which owns all of the stock of P1. Y and Y1 
are partnerships that are unrelated to the S group but may be related to 
the P group. Z is a corporation that is not related to any of the other 
parties.
[GRAPHIC] [TIFF OMITTED] TC17OC91.000

    (2) Direct acquisitions. Paragraphs (b), (c), and (d) of this 
section may be illustrated by the following examples:

    Example 1. Asset acquired from target by purchasing corporation. (a) 
On February 1 of Year 1, T sells an asset to P1 and recognizes gain. T's 
gain from the disposition of the asset is taken into account under Sec. 
1.1502-32 in determining S's basis in the T stock. On January 1 of Year 
2, P1 makes a qualified stock purchase of T from S. No section 338 
election is made for T.
    (b) T disposed of the asset during its consistency period, gain from 
the asset disposition is reflected in the basis of the T stock

[[Page 132]]

as of T's acquisition date (January 1 of Year 2), and the asset is owned 
both immediately after the asset disposition (February 1 of Year 1) and 
on T's acquisition date by P1, the corporation that acquired T stock in 
the qualified stock purchase. Consequently, under paragraph (b) of this 
section, paragraph (d)(1) of this section applies to the asset and P1's 
basis in the asset is T's adjusted basis in the asset immediately before 
the sale to P1.
    Example 2. Gain from section 338(h)(10) election reflected in stock 
basis. (a) On February 1 of Year 1, P1 makes a qualified stock purchase 
of T2 from T1. A section 338(h)(10) election is made for T2 and T2 
recognizes gain on each of its assets. T2's gain is taken into account 
under Sec. 1.1502-32 in determining S's basis in the T stock. On 
January 1 of Year 2, P1 makes a qualified stock purchase of T from S. No 
section 338 election is made for T.
    (b) Under paragraph (b)(2) of this section, the acquisition of the 
T2 stock is treated as an acquisition of T2's assets on February 1 of 
Year 1, because a section 338(h)(10) election is made for T2. The gain 
recognized by T2 under section 338(h)(10) is reflected in S's basis in 
the T stock as of T's acquisition date. Because the other requirements 
of paragraph (b) of this section are satisfied, paragraph (d)(1) of this 
section applies to the assets and new T2's basis in its assets is old 
T2's adjusted basis in the assets immediately before the disposition.
    Example 3. Corporation owning asset ceases affiliation with 
corporation purchasing target before target acquisition date. (a) On 
February 1 of Year 1, T sells an asset to P1 and recognizes gain. On 
December 1 of Year 1, P disposes of all of the P1 stock while P1 still 
owns the asset. On January 1 of Year 2, P makes a qualified stock 
purchase of T from S. No section 338 election is made for T.
    (b) Immediately after T's disposition of the asset, the asset is 
owned by P1 which is affiliated on that date with P, the corporation 
that acquired T stock in the qualified stock purchase. However, the 
asset is owned by a corporation (P1) that is no longer affiliated with P 
on T's acquisition date. Although the other requirements of paragraph 
(b) of this section are satisfied, the requirements of paragraph 
(b)(1)(iii) of this section are not satisfied. Consequently, the basis 
rules of paragraph (d) of this section do not apply to the asset by 
reason of P1's acquisition.
    (c) If P acquires all of the Z stock and P1 transfers the asset to Z 
on or before T's acquisition date (January 1 of Year 2), the asset is 
owned by an affiliate of P both on February 1 of Year 1 (P1) and on 
January 1 of Year 2 (Z). Consequently, all of the requirements of 
paragraph (b) of this section are satisfied and paragraph (d)(1) of this 
section applies to the asset and P1's basis in the asset is T's adjusted 
basis in the asset immediately before the sale to P1.
    Example 4. Gain reflected in stock basis notwithstanding offsetting 
loss or distribution. (a) On April 1 of Year 1, T sells an asset to P1 
and recognizes gain. In Year 1, T distributes an amount equal to the 
gain. On March 1 of Year 2, P makes a qualified stock purchase of T from 
S. No section 338 election is made for T.
    (b) Although, as a result of the distribution, there is no 
adjustment with respect to the T stock under Sec. 1.1502-32 for Year 1, 
T's gain from the disposition of the asset is considered reflected in 
S's basis in the T stock. The gain is considered to have been taken into 
account under Sec. 1.1502-32 in determining the adjustments to S's 
basis in the T stock because S's basis in the T stock is different from 
what it would have been had there been no gain.
    (c) If T distributes an amount equal to the gain on February 1 of 
Year 2, rather than in Year 1, the results would be the same because S's 
basis in the T stock is different from what it would have been had there 
been no gain. If the distribution in Year 2 is by reason of an election 
under Sec. 1.1502-32(f)(2), the results would be the same.
    (d) If, in Year 1, T does not make a distribution and the S group 
does not file a consolidated return, but, in Year 2, the S group does 
file a consolidated return and makes an election under Sec. 1.1502-
32(f)(2) for T, the results would be the same. S's basis in the T stock 
is different from what it would have been had there been no gain. 
Paragraph (c)(3) of this section (gain not considered reflected by 
reason of distributions) does not apply to the deemed distribution under 
the election because S and T are members of the same consolidated group. 
If T distributes an amount equal to the gain in Year 2 and no election 
is made under Sec. 1.1502-32(f)(2), the results would be the same.
    (e) If, in Year 1, T incurs an unrelated loss in an amount equal to 
the gain, rather than distributing an amount equal to the gain, the 
results would be the same because the gain is taken into account under 
Sec. 1.1502-32 in determining S's basis in the T stock.
    Example 5. Gain of a target affiliate reflected in stock basis after 
corporate reorganization. (a) On February 1 of Year 1, T3 sells an asset 
to P1 and recognizes gain. On March 1 of Year 1, S contributes the T3 
stock to T in a transaction qualifying under section 351. On January 15 
of Year 2, P1 makes a qualified stock purchase of T from S. No section 
338 election is made for T.
    (b) T3's gain from the asset sale is taken into account under Sec. 
1.1502-32 in determining S's basis in the T3 stock. Under section 358, 
the gain that is taken into account under Sec. 1.1502-32 in determining 
S's basis in the T3 stock is also taken into account in determining S's 
basis in the T stock following S's

[[Page 133]]

contribution of the T3 stock to T. Consequently, under paragraph (b) of 
this section, paragraph (d)(1) of this section applies to the asset and 
P1's basis in the asset is T3's adjusted basis in the asset immediately 
before the sale to P1.
    (c) If on March 1 of Year 1, rather than S contributing the T3 stock 
to T, S causes T3 to merge into T in a transaction qualifying under 
section 368(a)(1)(D), the results would be the same.
    Example 6. Gain not reflected if election under section 338 made. 
(a) On February 1 of Year 1, T1 sells an asset to P1 and recognizes 
gain. On January 1 of Year 2, P1 makes a qualified stock purchase of T1 
from T. A section 338 election (but not a section 338(h)(10) election) 
is made for T1.
    (b) Under paragraph (c)(2) of this section, because a section 338 
election is made for T1, T's basis in the T1 stock is considered not to 
reflect gain from the disposition. Consequently, the requirement of 
paragraph (b)(1)(ii) of this section is not satisfied. Thus, P1's basis 
in the asset is not determined under paragraph (d) of this section. 
Although the section 338 election for T1 results in a qualified stock 
purchase of T2, the requirement of paragraph (b)(1)(ii) of this section 
is not satisfied with respect to T2, whether or not a section 338 
election is made for T2.
    (c) If, on January 1 of Year 2, P1 makes a qualified stock purchase 
of T from S and a section 338 election for T, rather than T1, S's basis 
in the T stock is considered not to reflect gain from T1's disposition 
of the asset. However, the section 338 election for T results in a 
qualified stock purchase of T1. Because the gain is reflected in T's 
basis in the T1 stock, the requirements of paragraph (b) of this section 
are satisfied. Consequently, P1's basis in the asset is determined under 
paragraph (d)(1) of this section unless a section 338 election is also 
made for T1.

    (f) Extension of consistency to indirect acquisitions--(1) 
Introduction. If an arrangement exists (see paragraph (j)(5) of this 
section), this paragraph (f) generally extends the consistency rules to 
indirect acquisitions that have the same effect as direct acquisitions. 
For example, this paragraph (f) applies if, pursuant to an arrangement, 
target sells an asset to an unrelated person who then sells the asset to 
the purchasing corporation.
    (2) General rule. This paragraph (f) applies to an asset if, 
pursuant to an arrangement--
    (i) The asset is disposed of during the target consistency period;
    (ii) The basis of target stock as of, or at any time before, the 
target acquisition date reflects gain from the disposition of the asset; 
and
    (iii) The asset ownership requirements of paragraph (b)(1)(iii) of 
this section are not satisfied, but the asset is owned, at any time 
during the portion of the target consistency period following the target 
acquisition date, by--
    (A) A corporation--
    (1) The basis of whose stock, as of, or at any time before, the 
target acquisition date, reflects gain from the disposition of the 
asset; and
    (2) That is affiliated, at any time during the target consistency 
period, with a corporation that acquires stock of target in the 
qualified stock purchase; or
    (B) A corporation that at the time it owns the asset is affiliated 
with a corporation described in paragraph (f)(2)(iii)(A) of this 
section.
    (3) Basis of acquired assets. If this paragraph (f) applies to an 
asset, the principles of the basis rules of paragraph (d) of this 
section apply to the asset as of the date, following the disposition 
with respect to which gain is reflected in the basis of target's stock, 
that the asset is first owned by a corporation described in paragraph 
(f)(2)(iii) of this section. If the principles of the carryover basis 
rule of paragraph (d)(1) of this section apply to an asset, the asset's 
basis also is reduced (but not below zero) by the amount of any 
reduction in its basis occurring after the disposition with respect to 
which gain is reflected in the basis of target's stock.
    (4) Examples. This paragraph (f) may be illustrated by the following 
examples:

    Example 1. Acquisition of asset from unrelated party by purchasing 
corporation. (a) On February 1 of Year 1, T sells an asset to Z and 
recognizes gain. On February 15 of Year 1, P1 makes a qualified stock 
purchase of T from S. No section 338 election is made for T. P1 buys the 
asset from Z on March 1 of Year 1, before Z has reduced the basis of the 
asset through depreciation or otherwise.
    (b) Paragraph (b) of this section does not apply to the asset 
because the asset ownership requirements of paragraph (b)(1)(iii) of 
this section are not satisfied. However, the asset ownership 
requirements of paragraph (f)(2)(iii) of this section are satisfied 
because, during the portion of T's consistency period following T's 
acquisition date, the asset is

[[Page 134]]

owned by P1 while it is affiliated with T. Consequently, paragraph (f) 
of this section applies to the asset if there is an arrangement for T to 
dispose of the asset during T's consistency period, for the gain to be 
reflected in S's basis in the T stock as of T's acquisition date, and 
for P1 to own the asset during the portion of T's consistency period 
following T's acquisition date. If the arrangement exists, under 
paragraph (f)(3) of this section, P1's basis in the asset is determined 
as of March 1 of Year 1, under the principles of paragraph (d) of this 
section. Consequently, P1's basis in the asset is T's adjusted basis in 
the asset immediately before the sale to Z.
    (c) If P1 acquires the asset from Z on January 15 of Year 2 (rather 
than on March 1 of Year 1), and Z's basis in the asset has been reduced 
through depreciation at the time of the acquisition, P1's basis in the 
asset as of January 15 of Year 2 would be T's adjusted basis in the 
asset immediately before the sale to Z, reduced (but not below zero) by 
the amount of the depreciation. Z's basis and depreciation are 
determined without taking into account the basis rules of paragraph (d) 
of this section.
    (d) If P, rather than P1, acquires the asset from Z, the results 
would be the same.
    (e) If, on March 1 of Year 1, P1 acquires the Z stock, rather than 
acquiring the asset from Z, paragraph (f) of this section would apply to 
the asset if an arrangement exists. However, under paragraph (f)(3) of 
this section, Z's basis in the asset would be determined as of February 
1 of Year 1, the date the asset is first owned by a corporation (Z) 
described in paragraph (f)(2)(iii) of this section. Consequently, Z's 
basis in the asset as of February 1 of Year 1, determined under the 
principles of paragraph (d) of this section, would be T's adjusted basis 
in the asset immediately before the sale to Z.
    Example 2. Acquisition of asset from target by target affiliate. (a) 
On February 1 of Year 1, T contributes an asset to T1 in a transaction 
qualifying under section 351 and in which T recognizes gain under 
section 351(b) that is deferred under Sec. 1.1502-13. On March 1 of 
Year 1, P1 makes a qualified stock purchase of T from S and, pursuant to 
Sec. 1.1502-13, the deferred gain is taken into account by T 
immediately before T ceases to be a member of the S group. No section 
338 election is made for T.
    (b) Paragraph (b) of this section does not apply to the asset 
because the asset ownership requirements of paragraph (b)(1)(iii) of 
this section are not satisfied.
    (c) T1 is not described in paragraph (f)(2)(iii)(A) of this section 
because the basis of the T1 stock does not reflect gain from the 
disposition of the asset. Although, under section 358(a)(1)(B)(ii), T's 
basis in the T1 stock is increased by the amount of the gain, the gain 
is not taken into account directly or indirectly under Sec. 1.1502-32 
in determining T's basis in the T1 stock.
    (d) T1 is described in paragraph (f)(2)(iii)(B) of this section 
because, during the portion of T's consistency period following T's 
acquisition date, T1 owns the asset while it is affiliated with T, a 
corporation described in paragraph (f)(2)(iii)(A) of this section. 
Consequently, paragraph (f) of this section applies to the asset if 
there is an arrangement. Under paragraph (j)(5) of this section, the 
fact that, at the time T1 acquires the asset from T, T1 is related 
(within the meaning of section 267(b)) to T indicates that an 
arrangement exists.
    Example 3. Acquisition of asset from target and indirect acquisition 
of target stock. (a) On February 1 of Year 1, T sells an asset to P1 and 
recognizes gain. On March 1 of Year 1, Z makes a qualified stock 
purchase of T from S. No section 338 election is made for T. On January 
1 of Year 2, P1 acquires the T stock from Z other than in a qualified 
stock purchase.
    (b) The asset ownership requirements of paragraph (b)(1)(iii) of 
this section are not satisfied because the asset was never owned by Z, 
the corporation that acquired T stock in the qualified stock purchase 
(or by a corporation that was affiliated with Z at the time it owned the 
asset). However, because the asset is owned by P1 while it is affiliated 
with T during the portion of T's consistency period following T's 
acquisition date, paragraph (f) of this section applies to the asset if 
there is an arrangement. If there is an arrangement, the principles of 
the carryover basis rule of paragraph (d)(1) of this section apply to 
determine P1's basis in the asset unless Z makes a section 338 election 
for T. See paragraph (c)(2) of this section.
    (c) If P1 also makes a qualified stock purchase of T from Z, the 
results would be the same. If there is an arrangement, the principles of 
the carryover basis rule of paragraph (d)(1) of this section apply to 
determine P1's basis in the asset unless Z makes a section 338 election 
for T. However, these principles apply to determine P1's basis in the 
asset if P1, but not Z, makes a section 338 election for T. The basis of 
the T stock no longer reflects, as of T's acquisition date by P1, the 
gain from the disposition of the asset.
    (d) Assume Z purchases the T stock other than in a qualified stock 
purchase and P1 makes a qualified stock purchase of T from Z. Paragraph 
(b) of this section does not apply to the asset because gain from the 
disposition of the asset is not reflected in the basis of T's stock as 
of T's acquisition date (January 1 of Year 2). However, because the gain 
is reflected in S's basis in the T stock before T's acquisition date and 
the asset is owned by P1 while it is affiliated with T during the 
portion of T's consistency period following T's acquisition date, 
paragraph (f) of

[[Page 135]]

this section applies to the asset if there is an arrangement. If there 
is an arrangement, the principles of the carryover basis rule of 
paragraph (d)(1) of this section apply to determine P1's basis in the 
asset even if P1 makes a section 338 election for T. The basis of the T 
stock no longer reflects, as of T's acquisition date, the gain from the 
disposition of the asset.
    Example 4. Asset acquired from target affiliate by corporation that 
becomes its affiliate. (a) On February 1 of Year 1, T1 sells an asset to 
P1 and recognizes gain. On February 15 of Year 1, Z makes a qualified 
stock purchase of T from S. No section 338 election is made for T. On 
June 1 of Year 1, P1 acquires the T1 stock from T, other than in a 
qualified stock purchase.
    (b) The asset ownership requirements of paragraph (b)(1)(iii) of 
this section are not satisfied because the asset was never owned by Z, 
the corporation that acquired T stock in the qualified stock purchase 
(or by a corporation that was affiliated with Z at the time it owned the 
asset).
    (c) P1 is not described in paragraph (f)(2)(iii)(A) of this section 
because gain from the disposition of the asset is not reflected in the 
basis of the P1 stock.
    (d) P1 is described in paragraph (f)(2)(iii)(B) of this section 
because the asset is owned by P1 while P1 is affiliated with T1 during 
the portion of T's consistency period following T's acquisition date. T1 
becomes affiliated with Z, the corporation that acquired T stock in the 
qualified stock purchase, during T's consistency period, and, as of T's 
acquisition date, the basis of T1's stock reflects gain from the 
disposition of the asset. Consequently, paragraph (f) of this section 
applies to the asset if there is an arrangement.
    Example 5. De minimis rules. (a) On February 1 of Year 1, T sells an 
asset to P and recognizes gain. On February 15 of Year 1, T1 sells an 
asset to Z and recognizes gain. The aggregate amount realized by T and 
T1 on their respective sales of assets is not more than $250,000. On 
March 1 of Year 1, T3 sells an asset to P and recognizes gain. On April 
1 of Year 1, P makes a qualified stock purchase of T from S. No section 
338 election is made for T. On June 1 of Year 1, P1 buys from Z the 
asset sold by T1.
    (b) Under paragraph (b) of this section, the basis rules of 
paragraph (d) of this section apply to the asset sold by T. Under 
paragraph (f) of this section, the principles of the basis rules of 
paragraph (d) of this section apply to the asset sold by T1 if there is 
an arrangement. Because T3's gain is not reflected in the basis of the T 
stock, the basis rules of this section do not apply to the asset sold by 
T3.
    (c) The de minimis rule of paragraph (d)(3) of this section applies 
to an asset if the asset is not disposed of as part of the same 
arrangement as the acquisition of T and the aggregate amount realized 
for all assets otherwise subject to the carryover basis rules does not 
exceed $250,000. The aggregate amount realized by T and T1 does not 
exceed $250,000. (The asset sold by T3 is not taken into account for 
purposes of the de minimis rule.) Thus, the de minimis rule applies to 
the asset sold by T if the asset is not disposed of as part of the same 
arrangement as the acquisition of T.
    (d) If, under paragraph (f) of this section, the principles of the 
carryover basis rules of paragraph (d)(1) of this section otherwise 
apply to the asset sold by T1 because of an arrangement, the de minimis 
rules of this section do not apply to the asset because of the 
arrangement.
    (e) Assume on June 1 of Year 1, Z acquires the T1 stock from T, 
other than in a qualified stock purchase, rather than P1 buying the T1 
asset, and paragraph (f) of this section applies because there is an 
arrangement. Because the asset was disposed of and the T1 stock was 
acquired as part of the arrangement, the de minimis rules of this 
section do not apply to the asset.

    (g) Extension of consistency if dividends qualifying for 100 percent 
dividends received deduction are paid--(1) General rule for direct 
acquisitions from target. Unless a section 338 election is made for 
target, the basis rules of paragraph (d) of this section apply to an 
asset if--
    (i) Target recognizes gain (whether or not deferred) on disposition 
of the asset during the portion of the target consistency period that 
ends on the target acquisition date;
    (ii) The asset is owned, immediately after the asset disposition and 
on the target acquisition date, by a corporation that acquires stock of 
target in the qualified stock purchase (or by an affiliate of an 
acquiring corporation); and
    (iii) During the portion of the target consistency period that ends 
on the target acquisition date, the aggregate amount of dividends paid 
by target, to which section 243(a)(3) applies, exceeds the greater of--
    (A) $250,000; or
    (B) 125 percent of the yearly average amount of dividends paid by 
target, to which section 243(a)(3) applies, during the three calendar 
years immediately preceding the year in which the target consistency 
period begins (or, if shorter, the period target was in existence).
    (2) Other direct acquisitions having same effect. The basis rules of 
paragraph (d) of this section also apply to

[[Page 136]]

an asset if the effect of a transaction described in paragraph (g)(1) of 
this section is achieved through any combination of disposition of 
assets and payment of dividends to which section 243(a)(3) applies (or 
any other dividends eligible for a 100 percent dividends received 
deduction). See paragraph (h)(4) of this section for additional rules 
relating to target affiliates that are controlled foreign corporations.
    (3) Indirect acquisitions. The principles of paragraph (f) of this 
section also apply for purposes of this paragraph (g).
    (4) Examples. This paragraph (g) may be illustrated by the following 
examples:

    Example 1. Asset acquired from target paying dividends to which 
section 243(a)(3) applies. (a) The S group does not file a consolidated 
return. In Year 1, Year 2, and Year 3, T pays dividends to S to which 
section 243(a)(3) applies of $200,000, $250,000, and $300,000, 
respectively. On February 1 of Year 4, T sells an asset to P and 
recognizes gain. On January 1 of Year 5, P makes a qualified stock 
purchase of T from S. No section 338 election is made for T. During the 
portion of T's consistency period that ends on T's acquisition date, T 
pays S dividends to which section 243(a)(3) applies of $1,000,000.
    (b) Under paragraph (g)(1) of this section, paragraph (d) of this 
section applies to the asset. T recognizes gain on disposition of the 
asset during the portion of T's consistency period that ends on T's 
acquisition date, the asset is owned by P immediately after the 
disposition and on T's acquisition date, and T pays dividends described 
in paragraph (g)(1)(iii) of this section. Consequently, under paragraph 
(d)(1) of this section, P's basis in the asset is T's adjusted basis in 
the asset immediately before the sale to P.
    (c) If T is a controlled foreign corporation, the results would be 
the same if T pays dividends in the amount described in paragraph 
(g)(1)(iii) of this section that qualify for a 100 percent dividends 
received deduction. See sections 243(e) and 245.
    (d) If S and T3 file a consolidated return in which T, T1, and T2 do 
not join, the results would be the same because the dividends paid by T 
are still described in paragraph (g)(1)(iii) of this section.
    (e) If T, T1, and T2 file a consolidated return in which S and T3 do 
not join, the results would be the same because the dividends paid by T 
are still described in paragraph (g)(1)(iii) of this section.
    Example 2. Asset disposition by target affiliate achieving same 
effect. (a) The S group does not file a consolidated return. On February 
1 of Year 1, T2 sells an asset to P and recognizes gain. T pays 
dividends to S described in paragraph (g)(1)(iii) of this section. On 
January 1 of Year 2, P makes a qualified stock purchase of T from S. No 
section 338 election is made for T.
    (b) Paragraph (g)(1) of this section does not apply to the asset 
because T did not recognize gain on the disposition of the asset. 
However, under paragraph (g)(2) of this section, because the asset 
disposition by T2 and the dividends paid by T achieve the effect of a 
transaction described in paragraph (g)(1) of this section, the carryover 
basis rule of paragraph (d)(1) of this section applies to the asset. The 
effect was achieved because T2 is a lower-tier affiliate of T and the 
dividends paid by T to S reduce the value to S of T and its lower-tier 
affiliates.
    (c) If T2 is a controlled foreign corporation, the results would be 
the same because T2 is a lower-tier affiliate of T and the dividends 
paid by T to S reduce the value to S of T and its lower-tier affiliates.
    (d) If P buys an asset from T3, rather than T2, the asset 
disposition and the dividends do not achieve the effect of a transaction 
described in paragraph (g)(1) of this section because T3 is not a lower-
tier affiliate of T. Thus, the basis rules of paragraph (d) of this 
section do not apply to the asset. The results would be the same whether 
or not P also acquires the T3 stock (whether or not in a qualified stock 
purchase).
    Example 3. Dividends by target affiliate achieving same effect. (a) 
The S group does not file a consolidated return. On February 1 of Year 
1, T1 sells an asset to P and recognizes gain. On January 1 of Year 2, P 
makes a qualified stock purchase of T from S. No section 338 election is 
made for T. T does not pay dividends to S described in paragraph 
(g)(1)(iii) of this section. However, T1 pays dividends to T that would 
be described in paragraph (g)(1)(iii) of this section if T1 were a 
target.
    (b) Paragraph (g)(1) of this section does not apply to the asset 
because T did not recognize gain on the disposition of the asset and did 
not pay dividends described in paragraph (g)(1)(iii) of this section. 
Further, paragraph (g)(2) of this section does not apply because the 
dividends paid by T1 to T do not reduce the value to S of T and its 
lower-tier affiliates.
    (c) If both S and T own T1 stock and T1 pays dividends to S that 
would be described in paragraph (g)(1)(iii) of this section if T1 were a 
target, paragraph (g)(2) of this section would apply because the 
dividends paid by T1 to S reduce the value to S of T and its lower-tier 
affiliates. If T, rather than T1, sold the asset to P, the results would 
be the same. Further, if T and T1 pay dividends to S that, only when 
aggregated, would be described in paragraph (g)(1)(iii) of this section 
(if they were all paid by T), the results would be the same.

[[Page 137]]

    Example 4. Gain reflected by reason of dividends. (a) S and T file a 
consolidated return in which T1 and T2 do not join. On February 1 of 
Year 1, T1 sells an asset to P and recognizes gain. On January 1 of Year 
2, P makes a qualified stock purchase of T from S. No section 338 
election is made for T. T1 pays dividends to T that would be described 
in paragraph (g)(1)(iii) of this section if T1 were a target.
    (b) The requirements of paragraph (b) of this section are not 
satisfied because, under paragraph (c)(3) of this section, gain from 
T1's sale is not reflected in S's basis in the T stock by reason of the 
dividends paid by T1 to T.
    (c) Although the dividends paid by T1 to T do not reduce the value 
to S of T and its lower-tier affiliates, paragraph (g)(2) of this 
section applies because the dividends paid by T1 to T are taken into 
account under Sec. 1.1502-32 in determining S's basis in the T stock. 
Consequently, the carryover basis rule of paragraph (d)(1) of this 
section applies to the asset.

    (h) Consistency for target affiliates that are controlled foreign 
corporations--(1) In general. This paragraph (h) applies only if target 
is a domestic corporation. For additional rules that may apply with 
respect to controlled foreign corporations, see paragraph (g) of this 
section. The definitions and nomenclature of Sec. 1.338-2(b) and (c) 
and paragraph (e) of this section apply for purposes of this section.
    (2) Income or gain resulting from asset dispositions--(i) General 
rule. Income or gain of a target affiliate that is a controlled foreign 
corporation from the disposition of an asset is not reflected in the 
basis of target stock under paragraph (c) of this section unless the 
income or gain results in an inclusion under section 951(a)(1)(A), 
951(a)(1)(C), 1291 or 1293.
    (ii) Basis of controlled foreign corporation stock. If, by reason of 
paragraph (h)(2)(i) of this section, the carryover basis rules of this 
section apply to an asset, no increase in basis in the stock of a 
controlled foreign corporation under section 961(a) or 1293(d)(1), or 
under regulations issued pursuant to section 1297(b)(5), is allowed to 
target or a target affiliate to the extent the increase is attributable 
to income or gain described in paragraph (h)(2)(i) of this section. A 
similar rule applies to the basis of any property by reason of which the 
stock of the controlled foreign corporation is considered owned under 
section 958(a)(2) or 1297(a).
    (iii) Operating rule. For purposes of this paragraph (h)(2)--
    (A) If there is an income inclusion under section 951 (a)(1)(A) or 
(C), the shareholder's income inclusion is first attributed to the 
income or gain of the controlled foreign corporation from the 
disposition of the asset to the extent of the shareholder's pro rata 
share of such income or gain; and
    (B) Any income or gain under section 1293 is first attributed to the 
income or gain from the disposition of the asset to the extent of the 
shareholder's pro rata share of the income or gain.
    (iv) Increase in asset or stock basis--(A) If the carryover basis 
rules under paragraph (h)(2)(i) of this section apply to an asset, and 
the purchasing corporation disposes of the asset to an unrelated party 
in a taxable transaction and recognizes and includes in its U.S. gross 
income or the U.S. gross income of its shareholders the greater of the 
income or gain from the disposition of the asset by the selling 
controlled foreign corporation that was reflected in the basis of the 
target stock under paragraph (c) of this section, or the gain recognized 
on the asset by the purchasing corporation on the disposition of the 
asset, then the purchasing corporation or the target or a target 
affiliate, as appropriate, shall increase the basis of the selling 
controlled foreign corporation stock subject to paragraph (h)(2)(ii) of 
this section, as of the date of the disposition of the asset by the 
purchasing corporation, by the amount of the basis increase that was 
denied under paragraph (h)(2)(ii) of this section. The preceding 
sentence shall apply only to the extent that the controlled foreign 
corporation stock is owned (within the meaning of section 958(a)) by a 
member of the purchasing corporation's affiliated group.
    (B) If the carryover basis rules under paragraph (h)(2)(i) of this 
section apply to an asset, and the purchasing corporation or the target 
or a target affiliate, as appropriate, disposes of the stock of the 
selling controlled foreign corporation to an unrelated party in a 
taxable transaction and recognizes and includes in its U.S. gross income 
or the U.S. gross income of its shareholders

[[Page 138]]

the greater of the gain equal to the basis increase that was denied 
under paragraph (h)(2)(ii) of this section, or the gain recognized in 
the stock by the purchasing corporation or by the target or a target 
affiliate, as appropriate, on the disposition of the stock, then the 
purchasing corporation shall increase the basis of the asset, as of the 
date of the disposition of the stock of the selling controlled foreign 
corporation by the purchasing corporation or by the target or a target 
affiliate, as appropriate, by the amount of the basis increase that was 
denied pursuant to paragraph (h)(2)(i) of this section. The preceding 
sentence shall apply only to the extent that the asset is owned (within 
the meaning of section 958(a)) by a member of the purchasing 
corporation's affiliated group.
    (3) Stock issued by target affiliate that is a controlled foreign 
corporation. The exception to the carryover basis rules of this section 
provided in paragraph (d)(2)(iii) of this section does not apply to 
stock issued by a target affiliate that is a controlled foreign 
corporation. After applying the carryover basis rules of this section to 
the stock, the basis in the stock is increased by the amount treated as 
a dividend under section 1248 on the disposition of the stock (or that 
would have been so treated but for section 1291), except to the extent 
the basis increase is attributable to the disposition of an asset in 
which a carryover basis is taken under this section.
    (4) Certain distributions--(i) General rule. In the case of a target 
affiliate that is a controlled foreign corporation, paragraph (g) of 
this section applies with respect to the target affiliate by treating 
any reference to a dividend to which section 243(a)(3) applies as a 
reference to any amount taken into account under Sec. 1.1502-32 in 
determining the basis of target stock that is--
    (A) A dividend;
    (B) An amount treated as a dividend under section 1248 (or that 
would have been so treated but for section 1291); or
    (C) An amount included in income under section 951(a)(1)(B).
    (ii) Basis of controlled foreign corporation stock. If the carryover 
basis rules of this section apply to an asset, the basis in the stock of 
the controlled foreign corporation (or any property by reason of which 
the stock is considered owned under section 958(a)(2)) is reduced (but 
not below zero) by the sum of any amounts that are treated, solely by 
reason of the disposition of the asset, as a dividend, amount treated as 
a dividend under section 1248 (or that would have been so treated but 
for section 1291), or amount included in income under section 
951(a)(1)(B). For this purpose, any dividend, amount treated as a 
dividend under section 1248 (or that would have been so treated but for 
section 1291), or amount included in income under section 951(a)(1)(B) 
is considered attributable first to earnings and profits resulting from 
the disposition of the asset.
    (iii) Increase in asset or stock basis--(A) If the carryover basis 
rules under paragraphs (g) and (h)(4)(i) of this section apply to an 
asset, and the purchasing corporation disposes of the asset to an 
unrelated party in a taxable transaction and recognizes and includes in 
its U.S. gross income or the U.S. gross income of its shareholders the 
greater of the gain equal to the basis increase denied in the asset 
pursuant to paragraphs (g) and (h)(4)(i) of this section, or the gain 
recognized on the asset by the purchasing corporation on the disposition 
of the asset, then the purchasing corporation or the target or a target 
affiliate, as appropriate, shall increase the basis of the selling 
controlled foreign corporation stock subject to paragraph (h)(4)(ii) of 
this section, as of the date of the disposition of the asset by the 
purchasing corporation, by the amount of the basis reduction under 
paragraph (h)(4)(ii) of this section. The preceding sentence shall apply 
only to the extent that the controlled foreign corporation stock is 
owned (within the meaning of section 958(a)) by a member of the 
purchasing corporation's affiliated group.
    (B) If the carryover basis rules under paragraphs (g) and (h)(4)(i) 
of this section apply to an asset, and the purchasing corporation or the 
target or a target affiliate, as appropriate, disposes of the stock of 
the selling controlled foreign corporation to an unrelated party in a 
taxable transaction and recognizes and includes in its U.S.

[[Page 139]]

gross income or the U.S. gross income of its shareholders the greater of 
the amount of the basis reduction under paragraph (h)(4)(ii) of this 
section, or the gain recognized in the stock by the purchasing 
corporation or by the target or a target affiliate, as appropriate, on 
the disposition of the stock, then the purchasing corporation shall 
increase the basis of the asset, as of the date of the disposition of 
the stock of the selling controlled foreign corporation by the 
purchasing corporation or by the target or a target affiliate, as 
appropriate, by the amount of the basis increase that was denied 
pursuant to paragraphs (g) and (h)(4)(i) of this section. The preceding 
sentence shall apply only to the extent that the asset is owned (within 
the meaning of section 958(a)) by a member of the purchasing 
corporation's affiliated group.
    (5) Examples. This paragraph (h) may be illustrated by the following 
examples:

    Example 1. Stock of target affiliate that is a CFC. (a) The S group 
files a consolidated return; however, T2 is a controlled foreign 
corporation. On December 1 of Year 1, T1 sells the T2 stock to P and 
recognizes gain. On January 2 of Year 2, P makes a qualified stock 
purchase of T from S. No section 338 election is made for T.
    (b) Under paragraph (b)(1) of this section, paragraph (d) of this 
section applies to the T2 stock. Under paragraph (h)(3) of this section, 
paragraph (d)(2)(iii) of this section does not apply to the T2 stock. 
Consequently, paragraph (d)(1) of this section applies to the T2 stock. 
However, after applying paragraph (d)(1) of this section, P's basis in 
the T2 stock is increased by the amount of T1's gain on the sale of the 
T2 stock that is treated as a dividend under section 1248. Because P has 
a carryover basis in the T2 stock, the T2 stock is not considered 
purchased within the meaning of section 338(h)(3) and no section 338 
election may be made for T2.
    Example 2. Stock of target affiliate CFC; inclusion under subpart F. 
(a) The S group files a consolidated return; however, T2 is a controlled 
foreign corporation. On December 1 of Year 1, T2 sells an asset to P and 
recognizes subpart F income that results in an inclusion in T1's gross 
income under section 951(a)(1)(A). On January 2 of Year 2, P makes a 
qualified stock purchase of T from S. No section 338 election is made 
for T.
    (b) Because gain from the disposition of the asset results in an 
inclusion under section 951(a)(1)(A), the gain is reflected in the basis 
of the T stock as of T's acquisition date. See paragraph (h)(2)(i) of 
this section. Consequently, under paragraph (b)(1) of this section, 
paragraph (d)(1) of this section applies to the asset. In addition, 
under paragraph (h)(2)(ii) of this section, T1's basis in the T2 stock 
is not increased under section 961(a) by the amount of the inclusion 
that is attributable to the sale of the asset.
    (c) If, in addition to making a qualified stock purchase of T, P 
acquires the T2 stock from T1 on January 1 of Year 2, the results are 
the same for the asset sold by T2. In addition, under paragraph 
(h)(2)(ii) of this section, T1's basis in the T2 stock is not increased 
by the amount of the inclusion that is attributable to the gain on the 
sale of the asset. Further, under paragraph (h)(3) of this section, 
paragraph (d)(1) of this section applies to the T2 stock. However, after 
applying paragraph (d)(1) of this section, P's basis in the T2 stock is 
increased by the amount of T1's gain on the sale of the T2 stock that is 
treated as a dividend under section 1248. Finally, because P has a 
carryover basis in the T2 stock, the T2 stock is not considered 
purchased within the meaning of section 338(h)(3) and no section 338 
election may be made for T2.
    (d) If P makes a qualified stock purchase of T2 from T1, rather than 
of T from S, and T1's gain on the sale of T2 is treated as a dividend 
under section 1248, under paragraph (h)(1) of this section, paragraphs 
(h)(2) and (3) of this section do not apply because there is no target 
that is a domestic corporation. Consequently, the carryover basis rules 
of paragraph do not apply to the asset sold by T2 or the T2 stock.
    Example 3. Gain reflected by reason of section 1248 dividend; gain 
from non-subpart F asset. (a) The S group files a consolidated return; 
however, T2 is a controlled foreign corporation. In Years 1 through 4, 
T2 does not pay any dividends to T1 and no amount is included in T1's 
income under section 951(a)(1)(B). On December 1 of Year 4, T2 sells an 
asset with a basis of $400,000 to P for $900,000. T2's gain of $500,000 
is not subpart F income. On December 15 of Year 4, T1 sells T2, in which 
it has a basis of $600,000, to P for $1,600,000. Under section 1248, 
$800,000 of T1's gain of $1,000,000 is treated as a dividend. However, 
in the absence of the sale of the asset by T2 to P, only $300,000 would 
have been treated as a dividend under section 1248. On December 30 of 
Year 4, P makes a qualified stock purchase of T1 from T. No section 338 
election is made for T1.
    (b) Under paragraph (h)(4) of this section, paragraph (g)(2) of this 
section applies by reference to the amount treated as a dividend under 
section 1248 on the disposition of the T2 stock. Because the amount 
treated as a dividend is taken into account in determining T's basis in 
the T1 stock under Sec. 1.1502-32, the sale of the T2 stock and the 
deemed dividend have the effect of a transaction described in paragraph 
(g)(1) of this

[[Page 140]]

section. Consequently, paragraph (d)(1) of this section applies to the 
asset sold by T2 to P and P's basis in the asset is $400,000 as of 
December 1 of Year 4.
    (c) Under paragraph (h)(3) of this section, paragraph (d)(1) of this 
section applies to the T2 stock and P's basis in the T2 stock is 
$600,000 as of December 15 of Year 4. Under paragraphs (h)(3) and 
(4)(ii) of this section, however, P's basis in the T2 stock is increased 
by $300,000 (the amount of T1's gain treated as a dividend under section 
1248 ($800,000), other than the amount treated as a dividend solely as a 
result of the sale of the asset by T2 to P ($500,000)) to $900,000.
    (i) [Reserved]
    (j) Anti-avoidance rules. For purposes of this section--
    (1) Extension of consistency period. The target consistency period 
is extended to include any continuous period that ends on, or begins on, 
any day of the consistency period during which a purchasing corporation, 
or any person related, within the meaning of section 267(b) or 
707(b)(1), to a purchasing corporation, has an arrangement--
    (i) To purchase stock of target; or
    (ii) To own an asset to which the carryover basis rules of this 
section apply, taking into account the extension.
    (2) Qualified stock purchase and 12-month acquisition period. The 
12-month acquisition period is extended if, pursuant to an arrangement, 
a corporation acquires by purchase stock of another corporation 
satisfying the requirements of section 1504(a)(2) over a period of more 
than 12 months.
    (3) Acquisitions by conduits--(i) Asset ownership--(A) General rule. 
A corporation is treated as owning any portion of an asset attributed to 
the corporation from a conduit under section 318(a) (treating any asset 
as stock for this purpose), for purposes of--
    (1) The asset ownership requirements of this section; and
    (2) Determining whether a controlled foreign corporation is a target 
affiliate for purposes of paragraph (h) of this section.
    (B) Application of carryover basis rule. If the basis rules of this 
section apply to the asset, the basis rules of this section apply to the 
entire asset (not just the portion for which ownership is attributed).
    (ii) Stock acquisitions--(A) Purchase by conduit. A corporation is 
treated as purchasing stock of another corporation attributed to the 
corporation from a conduit under section 318(a) on the day the stock is 
purchased by the conduit. The corporation is not treated as purchasing 
the stock, however, if the conduit purchased the stock more than two 
years before the date the stock is first attributed to the corporation.
    (B) Purchase of conduit by corporation. If a corporation purchases 
an interest in a conduit (treating the interest as stock for this 
purpose), the corporation is treated as purchasing on that date any 
stock owned by a conduit on that date and attributed to the corporation 
under section 318(a) with respect to the interest in the conduit that 
was purchased.
    (C) Purchase of conduit by conduit. If a conduit (the first conduit) 
purchases an interest in a second conduit (treating the interest as 
stock for this purpose), the first conduit is treated as purchasing on 
that date any stock owned by a conduit on that date and attributed to 
the first conduit under section 318(a) with respect to the interest in 
the second conduit that was purchased.
    (4) Conduit. A person (other than a corporation) is a conduit as to 
a corporation if--
    (i) The corporation would be treated under section 318(a)(2)(A) and 
(B) (attribution from partnerships, estates, and trusts) as owning any 
stock owned by the person; and
    (ii) The corporation, together with its affiliates, would be treated 
as owning an aggregate of at least 50 percent of the stock owned by the 
person.
    (5) Existence of arrangement. The existence of an arrangement is 
determined under all the facts and circumstances. For an arrangement to 
exist, there need not be an enforceable, written, or unconditional 
agreement, and all the parties to the transaction need not have 
participated in each step of the transaction. One factor indicating the 
existence of an arrangement is the participation of a related party. For 
this purpose, persons are related if they are related within the meaning 
of section 267(b) or 707(b)(1).
    (6) Predecessor and successor--(i) Persons. A reference to a person 
(including target, target affiliate, and purchasing corporation) 
includes, as the context

[[Page 141]]

may require, a reference to a predecessor or successor. For this 
purpose, a predecessor is a transferor or distributor of assets to a 
person (the successor) in a transaction--
    (A) To which section 381(a) applies; or
    (B) In which the successor's basis for the assets is determined, 
directly or indirectly, in whole or in part, by reference to the basis 
of the transferor or distributor.
    (ii) Assets. A reference to an asset (the first asset) includes, as 
the context may require, a reference to any asset the basis of which is 
determined, directly or indirectly, in whole or in part, by reference to 
the first asset.
    (7) Examples. This paragraph (j) may be illustrated by the following 
examples:

    Example 1. Asset owned by conduit treated as owned by purchaser of 
target stock. (a) P owns a 60-percent interest in Y. On March 1 of Year 
1, T sells an asset to Y and recognizes gain. On January 1 of Year 2, P 
makes a qualified stock purchase of T from S. No section 338 election is 
made for T.
    (b) Under paragraph (j)(4) of this section, Y is a conduit with 
respect to P. Consequently, under paragraph (j)(3)(i)(A) of this 
section, P is treated as owning 60% of the asset on March 1 of Year 1 
and January 1 of Year 2. Because P is treated as owning part or all of 
the asset both immediately after the asset disposition and on T's 
acquisition date, paragraph (b) of this section applies to the asset. 
Consequently, paragraph (d)(1) of this section applies to the asset and 
Y's basis in the asset is T's adjusted basis in the asset immediately 
before the sale to Y.
    Example 2. Corporation whose stock is owned by conduit treated as 
affiliate. (a) P owns an 80-percent interest in Y. Y owns all of the 
stock of Z. On March 1 of Year 1, T sells an asset to Z and recognizes 
gain. On January 1 of Year 2, P makes a qualified stock purchase of T 
from S. No section 338 election is made for T.
    (b) Under paragraph (j)(4) of this section, Y is a conduit with 
respect to P. Consequently, under paragraph (j)(3)(i)(A) of this 
section, P is treated as owning 80% of the Z stock and Z is therefore 
treated as an affiliate of P for purposes of applying the asset 
ownership requirements of paragraph (b)(1)(iii) of this section. Because 
Z, an affiliate of P, owns the asset both immediately after the asset 
disposition and on T's acquisition date, paragraph (b) of this section 
applies to the asset, and the asset's basis is determined under 
paragraph (d) of this section.
    (c) If, instead of owning an 80-percent interest in Y, P owned a 79-
percent interest in Y, Z would not be treated as an affiliate of P and 
paragraph (b) of this section would not apply to the asset.
    Example 3. Qualified stock purchase by reason of stock purchase by 
conduit. (a) P owns a 90-percent interest in Y. Y owns a 60-percent 
interest in Y1. On February 1 of Year 2, T sells an asset to P and 
recognizes gain. On January 1 of Year 3, P purchases 70% of the T stock 
from S and Y1 purchases the remaining 30% of the T stock from S.
    (b) Under paragraph (j)(3)(ii)(A) of this section, P is treated as 
purchasing on January 1 of Year 3, the 16.2% of the T stock that is 
attributed to P from Y and Y1 under section 318(a). Thus, for purposes 
of this section, P is treated as making a qualified stock purchase of T 
on January 1 of Year 3, paragraph (b) of this section applies to the 
asset, and the asset's basis is determined under paragraph (d) of this 
section. However, because P is not treated as having made a qualified 
stock purchase of T for purposes of making an election under section 
338, no election can be made for T.
    (c) If Y1 purchases 20% of the T stock from S on December 1 of Year 
1, rather than 30% on January 1 of Year 3, P would be treated as 
purchasing 10.8% of the T stock on December 1 of Year 1. Thus, if 
paragraph (j)(2) of this section (relating to extension of the 12-month 
acquisition period) does not apply, P would not be treated as making a 
qualified stock purchase of T, because P is not treated as purchasing T 
stock satisfying the requirements of section 1504(a)(2) within a 12-
month period.
    Example 4. Successor asset. (a) On February 1 of Year 1, T sells 
stock of X to P1 and recognizes gain. On December 1 of Year 1, P1 
exchanges its X stock for stock in new X in a reorganization qualifying 
under section 368(a)(1)(F). On January 1 of Year 2, P1 makes a qualified 
stock purchase of T from S. No section 338 election is made for T.
    (b) The asset ownership requirements of paragraph (b)(1)(iii) of 
this section are satisfied because, under paragraph (j)(6)(ii) of this 
section, P1 is treated as owning the X stock on T's acquisition date. P1 
is treated as owning the X stock on that date because P1 owns the new X 
stock and P1's basis in the new X stock is determined by reference to 
P1's basis in the X stock. Consequently, under paragraph (d)(1) of this 
section, P1's basis in the X stock on February 1 of Year 1 is T's 
adjusted basis in the X stock immediately before the sale to P1.

[T.D. 8515, 59 FR 2972, Jan. 20, 1994, as amended by T.D. 8597, 60 FR 
36679, July 18, 1995; T.D. 8710, 62 FR 3459, Jan. 23, 1997. Redesignated 
by T.D. 8858, 65 FR 1246, Jan. 7, 2000, as amended by T.D. 8940, 66 FR 
9929, Feb. 13, 2001; 66 FR 17466, Mar. 30, 2001]

[[Page 142]]



Sec. 1.338-9  International aspects of section 338.

    (a) Scope. This section provides guidance regarding international 
aspects of section 338. As provided in Sec. 1.338-2(c)(18), a foreign 
corporation, a DISC, or a corporation for which a section 936 election 
has been made is considered a target affiliate for all purposes of 
section 338. In addition, stock described in section 338(h)(6)(B)(ii) 
held by a target affiliate is not excluded from the operation of section 
338.
    (b) Application of section 338 to foreign targets--(1) In general. 
For purposes of subtitle A, the deemed sale tax consequences, as defined 
in Sec. 1.338-2(c)(7), of a foreign target for which a section 338 
election is made (FT), and the corresponding earnings and profits, are 
taken into account in determining the taxation of FT and FT's direct and 
indirect shareholders. See, however, section 338(h)(16). For example, 
the income and earnings and profits of FT are determined, for purposes 
of sections 551, 951, 1248, and 1293, by taking into account the deemed 
sale tax sentence consequences.
    (2) Ownership of FT stock on the acquisition date. A person who 
transfers FT stock to the purchasing corporation on FT's acquisition 
date is considered to own the transferred stock at the close of FT's 
acquisition date. See, e.g., Sec. 1.951-1(f) (relating to determination 
of holding period for purposes of sections 951 through 964). If on the 
acquisition date the purchasing corporation owns a block of FT stock 
that was acquired before FT's acquisition date, the purchasing 
corporation is considered to own such block of stock at the close of the 
acquisition date.
    (3) Carryover FT stock--(i) Definition. FT stock is carryover FT 
stock if--
    (A) FT was a controlled foreign corporation within the meaning of 
section 957 (taking into account section 953(c)) at any time during the 
portion of the 12-month acquisition period that ends on the acquisition 
date; and
    (B) Such stock is owned as of the beginning of the day after FT's 
acquisition date by a person other than a purchasing corporation, or by 
a purchasing corporation if the stock is nonrecently purchased and is 
not subject to a gain recognition election under Sec. 1.338-5(d).
    (ii) Carryover of earnings and profits. The earnings and profits of 
old FT (and associated foreign taxes) attributable to the carryover FT 
stock (adjusted to reflect deemed sale tax sentence consequences) carry 
over to new FT solely for purposes of--
    (A) Characterizing an actual distribution with respect to a share of 
carryover FT stock as a dividend;
    (B) Characterizing gain on a post-acquisition date transfer of a 
share of carryover FT stock as a dividend under section 1248 (if such 
section is otherwise applicable);
    (C) Characterizing an investment of earnings in United States 
property as income under sections 951(a)(1)(B) and 956 (if such sections 
are otherwise applicable); and
    (D) Determining foreign taxes deemed paid under sections 902 and 960 
with respect to the amount treated as a dividend or income by virtue of 
this paragraph (b)(3)(ii) (subject to the operation of section 
338(h)(16)).
    (iii) Cap on carryover of earnings and profits. The amount of 
earnings and profits of old FT taken into account with respect to a 
share of carryover FT stock is limited to the amount that would have 
been included in gross income of the owner of such stock as a dividend 
under section 1248 if--
    (A) The shareholder transferred that share to the purchasing 
corporation on FT's acquisition date for a consideration equal to the 
fair market value of that share on that date; or
    (B) In the case of nonrecently purchased FT stock treated as 
carryover FT stock, a gain recognition election under section 
338(b)(3)(A) applied to that share. For purposes of the preceding 
sentence, a shareholder that is a controlled foreign corporation is 
considered to be a United States person, and the principle of section 
1248(c)(2)(D)(ii) (concerning a United States person's indirect 
ownership of stock in a foreign corporation) applies in determining the 
correct holding period.
    (iv) Post-acquisition date distribution of old FT earnings and 
profits. A post-acquisition date distribution with respect

[[Page 143]]

to a share of carryover FT stock is considered to be derived first from 
earnings and profits derived after FT's acquisition date and then from 
earnings and profits derived on or before FT's acquisition date.
    (v) Old FT earnings and profits unaffected by post-acquisition date 
deficits. The carryover amount for a share of carryover FT stock is not 
reduced by deficits in earnings and profits incurred by new FT. This 
rule applies for purposes of determining the amount of foreign taxes 
deemed paid regardless of the fact that there are no accumulated 
earnings and profits. For example, a distribution by new FT with respect 
to a share of carryover FT stock is treated as a dividend by the 
distributee to the extent of the carryover amount for that share 
notwithstanding that new FT has no earnings and profits.
    (vi) Character of FT stock as carryover FT stock eliminated upon 
disposition. A share of FT stock is not considered carryover FT stock 
after it is disposed of provided that all gain realized on the transfer 
is recognized at the time of the transfer, or that, if less than all of 
the realized gain is recognized, the recognized amount equals or exceeds 
the remaining carryover amount for that share.
    (4) Passive foreign investment company stock. Stock that is owned as 
of the beginning of the day after FT's acquisition date by a person 
other than a purchasing corporation, or by a purchasing corporation if 
the FT stock is nonrecently purchased stock not subject to a gain 
recognition election under Sec. 1.338-5(d), is treated as passive 
foreign investment company stock to the extent provided in section 
1297(b)(1).
    (c) Dividend treatment under section 1248(e). The principles of this 
paragraph (b) apply to shareholders of a domestic corporation subject to 
section 1248(e).
    (d) Allocation of foreign taxes. If a section 338 election is made 
for target (whether foreign or domestic), and target's taxable year 
under foreign law (if any) does not close at the end of the acquisition 
date, foreign income taxes attributable to the foreign taxable income 
earned by target during such foreign taxable year are allocated to old 
target and new target. Such allocation is made under the principles of 
Sec. 1.1502-76(b).
    (e) Operation of section 338(h)(16). [Reserved]
    (f) Examples. (1) Except as otherwise provided, all corporations use 
the calendar year as the taxable year, have no earnings and profits (or 
deficit) accumulated for any taxable year, and have only one class of 
outstanding stock.
    (2) This section may be illustrated by the following examples:

    Example 1. Gain recognition election for carryover FT stock. (a) A 
has owned 90 of the 100 shares of CFCT stock since CFCT was organized on 
March 13, 1989. P has owned the remaining 10 shares of CFCT stock since 
CFCT was organized. Those 10 shares constitute nonrecently purchased 
stock in P's hands within the meaning of section 338(b)(6)(B). On 
November 1, 1994, P purchases A's 90 shares of CFCT stock for $90,000 
and makes a section 338 election for CFCT. P also makes a gain 
recognition election under section 338(b)(3)(A) and Sec. 1.338-5(d).
    (b) CFCT's earnings and profits for its short taxable year ending on 
November 1, 1994, are $50,000, determined without taking into account 
the deemed asset sale. Assume A recognizes gain of $81,000 on the sale 
of the CFCT stock. Further, assume that CFCT recognizes gain of $40,000 
by reason of its deemed sale of assets under section 338(a)(1).
    (c) A's sale of CFCT stock to P is a transfer to which section 1248 
and paragraphs (b)(1) and (2) of this section apply. For purposes of 
applying section 1248(a) to A, the earnings and profits of CFCT for its 
short taxable year ending on November 1, 1994, are $90,000 (the earnings 
and profits for that taxable year as determined under Sec. 1.1248-2(e) 
($50,000) plus earnings from the deemed sale ($40,000)). Thus, A's 
entire gain is characterized as a dividend under section 1248 (but see 
section 338(h)(16)).
    (d) Assume that P recognizes a gain of $9,000 with respect to the 10 
shares of nonrecently purchased CFCT stock by reason of the gain 
recognition election. Because P is treated as selling the nonrecently 
purchased stock for all purposes of the Internal Revenue Code, section 
1248 applies. Thus, under Sec. 1.1248-2(e), $9,000 of the $90,000 of 
earnings and profits for 1994 are attributable to the block of 10 shares 
of CFCT stock deemed sold by P at the close of November 1, 1994 ($90,000 
x 10/100). Accordingly, P's entire gain on the deemed sale of 10 shares 
of CFCT stock is included under section 1248(a) in P's gross income as a 
dividend (but see section 338(h)(16)).
    Example 2. No gain recognition election for carryover FT stock. (a) 
Assume the same facts as in Example 1, except that P does not make a 
gain recognition election.

[[Page 144]]

    (b) The 10 shares of nonrecently purchased CFCT stock held by P is 
carryover FT stock under paragraph (b)(3) of this section. Accordingly, 
the earnings and profits (and attributable foreign taxes) of old CFCT 
carry over to new CFCT solely for purposes of that block of 10 shares. 
The amount of old CFCT's earnings and profits taken into account with 
respect to that block in the event, for example, of a distribution by 
new CFCT with respect to that block is the amount of the section 1248 
dividend that P would have recognized with respect to that block had it 
made a gain recognition election under section 338(b)(3)(A). Under the 
facts of Example 1, P would have recognized a gain of $9,000 with 
respect to that block, all of which would have been a section 1248 
dividend ($90,000 x 10/100). Accordingly, the carryover amount for the 
block of 10 shares of nonrecently purchased CFCT stock is $9,000.
    Example 3. Sale of controlled foreign corporation stock prior to and 
on the acquisition date. (a) X and Y, both U.S. corporations, have each 
owned 50% of the CFCT stock since 1986. Among CFCT's assets are assets 
the sale of which would generate subpart F income. On December 31, 1994, 
X sells its CFCT stock to P. On June 30, 1995, Y sells its CFCT stock to 
P. P makes a section 338 election for CFCT. In both 1994 and 1995, CFCT 
has subpart F income resulting from operations.
    (b) For taxable year 1994, X and Y are United States shareholders on 
the last day of CFCT's taxable year, so pursuant to section 951(a)(1)(A) 
each must include in income its pro rata share of CFCT's subpart F 
income for 1994. Because P's holding period in the CFCT stock acquired 
from X does not begin until January 1, 1995, P is not a United States 
shareholder on the last day of 1994 for purposes of section 951(a)(1)(A) 
(see Sec. 1.951-1(f)). X must then determine the extent to which 
section 1248 recharacterizes its gain on the sale of CFCT stock as a 
dividend.
    (c) For the short taxable year ending June 30, 1995, Y is considered 
to own the CFCT stock sold to P at the close of CFCT's acquisition date. 
Because the acquisition date is the last day of CFCT's taxable year, Y 
and P are United States shareholders on the last day of CFCT's taxable 
year. Pursuant to section 951(a)(1)(A), each must include its pro rata 
share of CFCT's subpart F income for the short taxable year ending June 
30, 1995. This includes any income generated on the deemed sale of 
CFCT's assets. Y must then determine the extent to which section 1248 
recharacterizes its gain on the sale of the CFCT stock as a dividend, 
taking into account any increase in CFCT's earnings and profits due to 
the deemed sale of assets.
    Example 4. Acquisition of control for purposes of section 951 prior 
to the acquisition date. FS owns 100% of the FT stock. On July 1, 1994, 
P buys 60% of the FT stock. On December 31, 1994, P buys the remaining 
40% of the FT stock and makes a section 338 election for FT. For tax 
year 1994, FT has earnings and profits of $1,000 (including earnings 
resulting from the deemed sale). The section 338 election results in 
$500 of subpart F income. As a result of the section 338 election, P 
must include in gross income the following amount under section 
951(a)(1)(A) (see Sec. 1.951-(b)(2)):


FT's subpart F income for 1994................................   $500.00
Less: reduction under section 951(a)(2)(A) for period (1-1-94     249.32
 through 7-1-94) during which FT is not a controlled foreign
 corporation ($500x182/365)...................................
                                                               ---------
Subpart F income as limited by section 951 (a)(2)(A)..........    250.68
P's pro rata share of subpart F income as determined under        150.41
 section 951(a)(2)(A) (60%x250.68)............................
 

    Example 5. Coordination with section 936. (a) T is a corporation for 
which a section 936 election has been made. P makes a qualified stock 
purchase of T and makes a section 338 election for T.
    (b) T's deemed sale of assets under section 338 constitutes a sale 
for purposes of subtitle A of the Internal Revenue Code, including 
section 936(a)(1)(A)(ii). To the extent that the assets deemed sold are 
used in the conduct of an active trade or business in a possession for 
purposes of section 936(a)(1)(A)(i), and assuming all the other 
conditions of section 936 are satisfied, the income from the deemed sale 
qualifies for the credit granted by section 936(a). The source of income 
from the deemed sale is determined as if the assets had actually been 
sold and is not affected for purposes of section 936 by section 
338(h)(16).
    (c) Because new T is treated a new corporation for purposes of 
subtitle A of the Internal Revenue Code, the three year testing period 
in section 936(a)(2)(A) begins again for new T on the day following T's 
acquisition date. Thus, if the character or source of old T's gross 
income disqualified it for the credit under section 936, a fresh start 
is allowed by a section 338 election.

[T.D. 8515, 59 FR 2978, Jan. 20, 1994. Redesignated by T.D. 8858, 65 FR 
1246, Jan. 7, 2000, as amended by T.D. 8940, 66 FR 9929, Feb. 13, 2001; 
66 FR 17466, Mar. 30, 2001]



Sec. 1.338-10  Filing of returns.

    (a) Returns including tax liability from deemed asset sale--(1) In 
general. Except as provided in paragraphs (a)(2) and (3) of this 
section, any deemed sale tax consequences are reported on the final 
return of old target filed for old target's taxable year that ends at 
the close of the acquisition date. Paragraphs (a)(2), (3) and (4) of 
this section do not apply to elections under section 338(h)(10). If old 
target is the common

[[Page 145]]

parent of an affiliated group, the final return may be a consolidated 
return (any such consolidated return must also include any deemed sale 
tax consequences of any members of the consolidated group that are 
acquired by the purchasing corporation on the same acquisition date as 
old target).
    (2) Old target's final taxable year otherwise included in 
consolidated return of selling group--(i) General rule. If the selling 
group files a consolidated return for the period that includes the 
acquisition date, old target is disaffiliated from that group 
immediately before the deemed asset sale and must file a deemed sale 
return separate from the group, which includes only the deemed sale tax 
consequences and the carryover items specified in paragraph (a)(2)(iii) 
of this section. The deemed asset sale occurs at the close of the 
acquisition date and is the last transaction of old target and the only 
transaction reported on the separate return. Except as provided in Sec. 
1.338-1(d) (regarding certain transactions on the acquisition date), any 
transactions of old target occurring on the acquisition date other than 
the deemed asset sale are included in the selling group's consolidated 
return. A deemed sale return includes a combined deemed sale return as 
defined in paragraph (a)(4) of this section.
    (ii) Separate taxable year. The deemed asset sale included in the 
deemed sale return under this paragraph (a)(2) occurs in a separate 
taxable year, except that old target's taxable year of the sale and the 
consolidated year of the selling group that includes the acquisition 
date are treated as the same year for purposes of determining the number 
of years in a carryover or carryback period.
    (iii) Carryover and carryback of tax attributes. Target's attributes 
may be carried over to, and carried back from, the deemed sale return 
under the rules applicable to a corporation that ceases to be a member 
of a consolidated group.
    (iv) Old target is a component member of purchasing corporation's 
controlled group. For purposes of its deemed sale return, target is a 
component member of the controlled group of corporations including the 
purchasing corporation unless target is treated as an excluded member 
under section 1563(b)(2).
    (4) Combined deemed sale return--(i) General rule. Under section 
338(h)(15), a combined deemed sale return (combined return) may be filed 
for all targets from a single selling consolidated group (as defined in 
Sec. 1.338(h)(10)-1(b)(3)) that are acquired by the purchasing 
corporation on the same acquisition date and that otherwise would be 
required to file separate deemed sale returns. The combined return must 
include all such targets. For example, T and T1 may be included in a 
combined return if--
    (A) T and T1 are directly owned subsidiaries of S;
    (B) S is the common parent of a consolidated group; and
    (C) P makes qualified stock purchases of T and T1 on the same 
acquisition date.
    (ii) Gain and loss offsets. Gains and losses recognized on the 
deemed asset sales by targets included in a combined return are treated 
as the gains and losses of a single target. In addition, loss carryovers 
of a target that were not subject to the separate return limitation year 
restrictions (SRLY restrictions) of the consolidated return regulations 
while that target was a member of the selling consolidated group may be 
applied without limitation to the gains of other targets included in the 
combined return. If, however, a target has loss carryovers that were 
subject to the SRLY restrictions while that target was a member of the 
selling consolidated group, the use of those losses in the combined 
return continues to be subject to those restrictions, applied in the 
same manner as if the combined return were a consolidated return. A 
similar rule applies, when appropriate, to other tax attributes.
    (iii) Procedure for filing a combined return. A combined return is 
made by filing a single corporation income tax return in lieu of 
separate deemed sale returns for all targets required to be included in 
the combined return. The combined return reflects the deemed asset sales 
of all targets required to be included in the combined return. If the 
targets included in the combined return constitute a single affiliated 
group within the meaning of section

[[Page 146]]

1504(a), the income tax return is signed by an officer of the common 
parent of that group. Otherwise, the return must be signed by an officer 
of each target included in the combined return. Rules similar to the 
rules in Sec. 1.1502-75(j) apply for purposes of preparing the combined 
return. The combined return must include a statement entitled, 
``ELECTION TO FILE A COMBINED RETURN UNDER SECTION 338(h)(15).'' The 
statement must include--
    (A) The name, address, and employer identification number of each 
target required to be included in the combined return; and
    (B) The following declaration: EACH TARGET IDENTIFIED IN THIS 
ELECTION TO FILE A COMBINED RETURN CONSENTS TO THE FILING OF A COMBINED 
RETURN.
    (iv) Consequences of filing a combined return. Each target included 
in a combined return is severally liable for any tax associated with the 
combined return. See Sec. 1.338-1(b)(3).
    (5) Deemed sale excluded from purchasing corporation's consolidated 
return. Old target may not be considered a member of any affiliated 
group that includes the purchasing corporation with respect to its 
deemed asset sale.
    (6) Due date for old target's final return--(i) General rule. Old 
target's final return is generally due on the 15th day of the third 
calendar month following the month in which the acquisition date occurs. 
See section 6072 (time for filing income tax returns).
    (ii) Application of Sec. 1.1502-76(c)--(A) In general. Section 
1.1502-76(c) applies to old target's final return if old target was a 
member of a selling group that did not file consolidated returns for the 
taxable year of the common parent that precedes the year that includes 
old target's acquisition date. If the selling group has not filed a 
consolidated return that includes old target's taxable period that ends 
on the acquisition date, target may, on or before the final return due 
date (including extensions), either--
    (1) File a deemed sale return on the assumption that the selling 
group will file the consolidated return; or
    (2) File a return for so much of old target's taxable period as ends 
at the close of the acquisition date on the assumption that the 
consolidated return will not be filed.
    (B) Deemed extension. For purposes of applying Sec. 1.1502-
76(c)(2), an extension of time to file old target's final return is 
considered to be in effect until the last date for making the election 
under section 338.
    (C) Erroneous filing of deemed sale return. If, under this paragraph 
(a)(6)(ii), target files a deemed sale return but the selling group does 
not file a consolidated return, target must file a substituted return 
for old target not later than the due date (including extensions) for 
the return of the common parent with which old target would have been 
included in the consolidated return. The substituted return is for so 
much of old target's taxable year as ends at the close of the 
acquisition date. Under Sec. 1.1502-76(c)(2), the deemed sale return is 
not considered a return for purposes of section 6011 (relating to the 
general requirement of filing a return) if a substituted return must be 
filed.
    (D) Erroneous filing of return for regular tax year. If, under this 
paragraph (a)(6)(ii), target files a return for so much of old target's 
regular taxable year as ends at the close of the acquisition date but 
the selling group files a consolidated return, target must file an 
amended return for old target not later than the due date (including 
extensions) for the selling group's consolidated return. (The amended 
return is a deemed sale return.)
    (E) Last date for payment of tax. If either a substituted or amended 
final return of old target is filed under this paragraph (a)(6)(ii), the 
last date prescribed for payment of tax is the final return due date (as 
defined in paragraph (a)(6)(i) of this section).
    (7) Examples. The following examples illustrate this paragraph (a):

    Example 1. (i) S is the common parent of a consolidated group that 
includes T. The S group files calendar year consolidated returns. At the 
close of June 30 of Year 1, P makes a qualified stock purchase of T from 
S. P makes a section 338 election for T, and T's deemed asset sale 
occurs as of the close of T's acquisition date (June 30).
    (ii) T is considered disaffiliated for purposes of reporting the 
deemed sale tax consequences. Accordingly, T is included in the S 
group's consolidated return through T's

[[Page 147]]

acquisition date except that the tax liability for the deemed sale tax 
consequences is reported in a separate deemed sale return of T. Provided 
that T is not treated as an excluded member under section 1563(b)(2), T 
is a component member of P's controlled group for the taxable year of 
the deemed asset sale, and the taxable income bracket amounts available 
in calculating tax on the deemed sale return must be limited 
accordingly.
    (iii) If P purchased the stock of T at 10 a.m. on June 30 of Year 1, 
the results would be the same. See paragraph (a)(2)(i) of this section.
    Example 2. The facts are the same as in Example 1, except that the S 
group does not file consolidated returns. T must file a separate return 
for its taxable year ending on June 30 of Year 1, which return includes 
the deemed asset sale.

    (b) Waiver--(1) Certain additions to tax. An addition to tax or 
additional amount (addition) under subchapter A of chapter 68 of the 
Internal Revenue Code arising on or before the last day for making the 
election under section 338 because of circumstances that would not exist 
but for an election under section 338 is waived if--
    (i) Under the particular statute the addition is excusable upon a 
showing of reasonable cause; and
    (ii) Corrective action is taken on or before the last day.
    (2) Notification. The Internal Revenue Service should be notified at 
the time of correction (e.g., by attaching a statement to a return that 
constitutes corrective action) that the waiver rule of this paragraph 
(b) is being asserted.
    (3) Elections or other actions required to be specified on a timely 
filed return--(i) In general. If paragraph (b)(1) of this section 
applies or would apply if there were an underpayment, any election or 
other action that must be specified on a timely filed return for the 
taxable period covered by the late filed return described in paragraph 
(b)(1) of this section is considered timely if specified on a late-filed 
return filed on or before the last day for making the election under 
section 338.
    (ii) New target in purchasing corporation's consolidated return. If 
new target is includible for its first taxable year in a consolidated 
return filed by the affiliated group of which the purchasing corporation 
is a member on or before the last day for making the election under 
section 338, any election or other action that must be specified in a 
timely filed return for new target's first taxable year (but which is 
not specified in the consolidated return) is considered timely if 
specified in an amended return filed on or before such last day, at the 
place where the consolidated return was filed.
    (4) Examples. The following examples illustrate this paragraph (b):

    Example 1. T is an unaffiliated corporation with a tax year ending 
March 31. At the close of September 20 of Year 1, P makes a qualified 
stock purchase of T. P does not join in filing a consolidated return. P 
makes a section 338 election for T on or before June 15 of Year 2, which 
causes T's taxable year to end as of the close of September 20 of Year 
1. An income tax return for T's taxable period ending on September 20 of 
Year 1 was due on December 15 of Year 1. Additions to tax for failure to 
file a return and to pay tax shown on a return will not be imposed if 
T's return is filed and the tax paid on or before June 15 of Year 2. 
(This waiver applies even if the acquisition date coincides with the 
last day of T's former taxable year, i.e., March 31 of Year 2.) Interest 
on any underpayment of tax for old T's short taxable year ending 
September 20 of Year 1 runs from December 15 of Year 1. A statement 
indicating that the waiver rule of this paragraph is being asserted 
should be attached to T's return.
    Example 2. Assume the same facts as in Example 1. Assume further 
that new T adopts the calendar year by filing, on or before June 15 of 
Year 2, its first return (for the period beginning on September 21 of 
Year 1 and ending on December 31 of Year 1) indicating that a calendar 
year is chosen. See Sec. 1.338-1(b)(1). Any additions to tax or amounts 
described in this paragraph (b) that arise because of the late filing of 
a return for the period ending on December 31 of Year 1 are waived, 
because they are based on circumstances that would not exist but for the 
section 338 election. Notwithstanding this waiver, however, the return 
is still considered due March 15 of Year 2, and interest on any 
underpayment runs from that date.
    Example 3. Assume the same facts as in Example 2, except that T's 
former taxable year ends on October 31. Although prior to the election 
old T had a return due on January 15 of Year 2 for its year ending 
October 31 of Year 1, that return need not be filed because a timely 
election under section 338 was made. Instead, old T must file a final 
return for the period ending on September 20 of Year 1, which is due on 
December 15 of Year 1.
    (c) Effective/applicability date. Paragraph (a)(4)(iii) of this 
section applies to any taxable year beginning on or

[[Page 148]]

after May 30, 2006. However, taxpayers may apply paragraph (a)(4)(iii) 
of this section to any original Federal income tax return (including any 
amended return filed on or before the due date (including extensions) of 
such original return) timely filed on or after May 30, 2006. For taxable 
years beginning before May 30, 2006, see Sec. 1.338-10 as contained in 
26 CFR part 1 in effect on April 1, 2006.

[T.D. 8940, 66 FR 9948, Feb. 13, 2001, as amended by T.D. 9264, 71 FR 
30596, May 30, 2006; T.D. 9329, 72 FR 32798, June 14, 2007]



Sec. 1.338-11  Effect of section 338 election on insurance company targets.

    (a) In general. This section provides rules that apply when an 
election under section 338 is made for a target that is an insurance 
company. The rules in this section apply in addition to those generally 
applicable upon the making of an election under section 338. In the case 
of a conflict between the provisions of this section and other 
provisions of the Internal Revenue Code or regulations, the rules set 
forth in this section determine the Federal income tax treatment of the 
parties and the transaction when a section 338 election is made for an 
insurance company target.
    (b) Computation of ADSP and AGUB--(1) Reserves taken into account as 
a liability. Old target's tax reserves are the reserves for Federal 
income tax purposes for any insurance, annuity, and reinsurance 
contracts deemed sold by old target to new target in the deemed asset 
sale. The amount of old target's tax reserves is the amount that is 
properly taken into account by old target for the contracts at the close 
of the taxable year that includes the deemed sale tax consequences 
(before giving effect to the deemed asset sale and assumption 
reinsurance transaction). Old target's tax reserves are a liability of 
old target taken into account in determining ADSP under Sec. 1.338-4 
and a liability of new target taken into account in determining AGUB 
under Sec. 1.338-5.
    (2) Allocation of ADSP and AGUB to specific insurance contracts. For 
purposes of allocating AGUB and ADSP under Sec. Sec. 1.338-6 and 1.338-
7, the fair market value of a specific insurance, reinsurance or annuity 
contract or group of insurance, reinsurance or annuity contracts 
(insurance contracts) is the amount of the ceding commission a willing 
reinsurer would pay a willing ceding company in an arm's length 
transaction for the reinsurance of the contracts if the gross 
reinsurance premium for the contracts were equal to old target's tax 
reserves for the contracts. See Sec. 1.197-2(g)(5) for rules concerning 
the treatment of the amount allocable to insurance contracts acquired in 
the deemed asset sale.
    (c) Application of assumption reinsurance principles--(1) In 
general. If a target is an insurance company, the deemed sale of 
insurance contracts is treated for Federal income tax purposes as an 
assumption reinsurance transaction between old target, as the reinsured 
or ceding company, and new target, as the reinsurer or acquiring 
company, at the close of the acquisition date. The Federal income tax 
treatment of the assumption reinsurance transaction is determined under 
the applicable provisions of subchapter L, chapter 1, subtitle A of the 
Internal Revenue Code, as modified by the rules set forth in this 
section.
    (2) Reinsurance premium. Old target is deemed to pay a gross amount 
of premium in the assumption reinsurance transaction equal to the amount 
of old target's tax reserves for the insurance contracts that are 
acquisition date assets (acquired contracts). New target is deemed to 
receive a reinsurance premium in the amount of old target's tax reserves 
for the acquired contracts. See paragraph (d) of this section for 
circumstances in which new target is deemed to receive additional 
premium. See Sec. 1.817-4(d)(2) for old target's and new target's 
treatment of the premium.
    (3) Ceding commission. Old target is deemed to receive a ceding 
commission in an amount equal to the amount of ADSP allocated to the 
acquired contracts, as determined under Sec. Sec. 1.338-6 and 1.338-7 
and paragraph (b) of this section. New target is deemed to pay a ceding 
commission in an amount equal to the amount of AGUB allocated to the 
acquired contracts, as determined under Sec. Sec. 1.338-6 and 1.338-7 
and paragraph (b) of this section. See Sec. 1.817-

[[Page 149]]

4(d)(2) for old target's and new target's treatment of the ceding 
commission.
    (4) Examples. The following examples illustrate this paragraph (c):

    Example 1. (i) Facts. On January 1, 2003, T, an insurance company, 
has the following assets with the following fair market values: $10 
cash, $30 of securities, $10 of equipment, a life insurance contract 
having a value, under paragraph (b)(2) of this section, of $17, and 
goodwill and going concern value. T has tax reserves of $50 and no other 
liabilities. On January 1, 2003, P purchases all of the stock of T for 
$16 and makes a section 338 election for T. For purposes of the 
capitalization requirements of section 848, assume new T has $20 of 
general deductions in its first taxable year ending on December 31, 
2003, and earns no other premiums during the year.
    (ii) Analysis. (A) For Federal income tax purposes, the section 338 
election results in a deemed sale of the assets of old T to new T. Old 
T's ADSP is $66 ($16 amount realized for the T stock plus $50 
liabilities). New T's AGUB also is $66 ($16 basis for the T stock plus 
$50 liabilities). See paragraph (b)(1) of this section. Each of the AGUB 
and ADSP is allocated under the residual method of Sec. 1.338-6 to 
determine the purchase or sale price of each asset transferred. Each of 
the AGUB and ADSP is allocated as follows: $10 to cash (Class I), $30 to 
the securities (Class II), $10 to equipment (Class V), $16 to the life 
insurance contract (Class VI), and $0 to goodwill and going concern 
value (Class VII).
    (B) Under section 1001, old T's amount realized for the securities 
is $30 and for the equipment is $10. As a result of the deemed asset 
sale, there is an assumption reinsurance transaction between old T (as 
ceding company) and new T (as reinsurer) at the close of the acquisition 
date for the life insurance contract issued by old T. See paragraph 
(c)(1) of this section. Although the assumption reinsurance transaction 
results in a $50 decrease in old T's reserves, which is taxable income 
to old T, the reinsurance premium paid by old T is deductible by old T. 
Under paragraph (c)(2) of this section, old T is deemed to pay a 
reinsurance premium equal to the reserve for the life insurance contract 
immediately before the deemed asset sale ($50) and is deemed to receive 
a ceding commission from new T. Under paragraph (c)(3) of this section, 
the portion of the ADSP allocated to the life insurance contract is $16; 
thus, the ceding commission is $16. Old T, therefore, is deemed to pay 
new T a reinsurance premium of $34 ($50 - $16 = $34). Old T also has $34 
of net negative consideration for purposes of section 848. See paragraph 
(f) of this section for rules relating to the effect of a section 338 
election on the capitalization of amounts under section 848.
    (C) New T obtains an initial basis of $30 in the securities and $10 
in the equipment. New T is deemed to receive a reinsurance premium from 
old T in an amount equal to the $50 of reserves for the life insurance 
contract and to pay old T a $16 ceding commission for the contract. See 
paragraphs (c)(2) and (3) of this section. Accordingly, new T includes 
$50 of premium in income and deducts $50 for its increase in reserves. 
For purposes of section 848, new T has $34 of net positive consideration 
for the deemed assumption reinsurance transaction. Because the only 
contract involved in the deemed assumption reinsurance transaction is a 
life insurance contract, new T must capitalize $2.62 ($34 x 7.7% = 
$2.62) under section 848. New T will amortize the $2.62 as provided 
under section 848. New T's adjusted basis in the life insurance 
contract, which is an amortizable section 197 intangible, is $13.38, the 
excess of the $16 ceding commission over the $2.62 capitalized under 
section 848. See section 197 and Sec. 1.197-2(g)(5). New T deducts the 
$2.62 of the ceding commission that is not amortizable under section 197 
because it is reflected in the amount capitalized under section 848 and 
also deducts the remaining $17.38 of its general deductions.
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
the life insurance contract has a value of $0 and the fair market value 
of T's securities are $60. Thus, to reinsure the contract in an arm's 
length transaction, T would have to pay the reinsurer a reinsurance 
premium in excess of T's $50 of tax reserves for the contract.
    (ii) Analysis. (A) For Federal income tax purposes, the section 338 
election results in a deemed sale of the assets of old T to new T. Old 
T's ADSP is $66 ($16 amount realized for the T stock plus $50 
liabilities). New T's AGUB also is $66 ($16 basis for the T stock plus 
$50 liabilities). See paragraph (b)(1) of this section. Each of the AGUB 
and ADSP is allocated under the residual method of Sec. 1.338-6 to 
determine the purchase or sale price of each asset transferred. Each of 
the AGUB and ADSP is allocated as follows: $10 to cash (Class I), $56 to 
the securities (Class II), $0 to the equipment (Class V), $0 to the life 
insurance contract (Class VI), and $0 to goodwill and going concern 
value (Class VII).
    (B) Under section 1001, old T's amount realized for the securities 
is $56 and for the equipment is $0. As a result of the deemed asset 
sale, there is an assumption reinsurance transaction between old T (as 
ceding company) and new T (as reinsurer) at the close of the acquisition 
date for the life insurance contract issued by old T. See paragraph 
(c)(1) of this section. Although the assumption reinsurance transaction 
results in a $50 decrease in old T's reserves, which is taxable income 
to old T, the reinsurance premium deemed paid by old T to new T is 
deductible by old T. Under paragraph (c)(2) of

[[Page 150]]

this section, old T is deemed to pay a reinsurance premium equal to the 
reserve for the life insurance contract immediately before the deemed 
asset sale ($50), and is deemed to receive from new T a ceding 
commission equal to the amount of AGUB allocated to the life insurance 
contract ($0), as provided in paragraph (c)(3) of this section. Old T 
also has $50 of net negative consideration for purposes of section 848. 
See paragraph (f) of this section for rules relating to the effect of a 
section 338 election on capitalization amounts under section 848.
    (C) New T obtains an initial basis of $56 in the securities (with a 
fair market value of $60) and $0 in the equipment (with a fair market 
value of $10). New T is deemed to receive a reinsurance premium from old 
T in an amount equal to the $50 of reserves for the life insurance 
contract. Accordingly, new T includes $50 of premium in income and 
deducts $50 for its increase in reserves. For purposes of section 848, 
new T has $50 of net positive consideration for the deemed assumption 
reinsurance transaction. Because the only contract involved in the 
assumption reinsurance transaction is a life insurance contract, new T 
must capitalize $3.85 ($50 x 7.7%) under section 848 from the 
transaction and deducts the remaining $16.15 of its general deductions. 
Because new T allocates $0 of the AGUB to the insurance contract, no 
amount is amortizable under section 197 with respect to the insurance 
contract. See Sec. 1.338-11T(d) for rules on adjustments required if 
new T increases its reserves for, or reinsures at a loss, the acquired 
life insurance contract.

    (d) Reserve increases by new target after the deemed asset sale--(1) 
In general. If in new target's first taxable year or any subsequent 
year, new target increases its reserves for any acquired contracts, new 
target is treated as receiving an additional premium, which is computed 
under paragraph (d)(3) of this section, in the assumption reinsurance 
transaction described in paragraph (c)(1) of this section. New target 
includes the additional premium in gross income for the taxable year in 
which new target increases its reserves for acquired contracts. New 
target's increase in reserves for the insurance contracts acquired in 
the deemed asset sale is a liability of new target not originally taken 
into account in determining AGUB that is subsequently taken into 
account. Thus, AGUB is increased by the amount of the additional premium 
included in new target's gross income. See Sec. Sec. 1.338-5(b)(2)(ii) 
and 1.338-7. Old target has no deduction under this paragraph (d) and 
makes no adjustments under Sec. Sec. 1.338-4(b)(2)(ii) and 1.338-7.
    (2) Exceptions. New target is not treated as receiving additional 
premium under paragraph (d)(1) of this section if--
    (i) It is under state receivership as of the close of the taxable 
year for which the increase in reserves occurs; or
    (ii) It is required by section 807(f) to spread the reserve increase 
over the 10 succeeding taxable years.
    (3) Amount of additional premium--(i) In general. The additional 
premium taken into account under this paragraph (d) is an amount equal 
to the sum of the positive amounts described in paragraphs (d)(3)(ii) 
and (d)(3)(iii) of this section. However, the additional premium cannot 
exceed the limitation described in paragraph (d)(4) of this section.
    (ii) Increases in unpaid loss reserves. The positive amount with 
respect to unpaid loss reserves is computed using the formula A/B x (C-
[D + E]) where--
    (A) A equals old target's discounted unpaid losses (determined under 
section 846) included in AGUB under paragraph 11(b)(1) of this section;
    (B) B equals old target's undiscounted unpaid losses (determined 
under section 846(b)(1)) as of the close of the acquisition date;
    (C) C equals new target's undiscounted unpaid losses (determined 
under section 846(b)(1)) at the end of the taxable year that are 
attributable to losses incurred by old target on or before the 
acquisition date;
    (D) D (which may be a negative number) equals old target's 
undiscounted unpaid losses as of the close of the acquisition date, 
reduced by the cumulative amount of losses, loss adjustment expenses, 
and reinsurance premiums paid by new target through the end of the 
taxable year for losses incurred by old target on or before the 
acquisition date; and
    (E) E equals the amount obtained by dividing the cumulative amount 
of reserve increases taken into account under this paragraph (d) in 
prior taxable years by A/B.
    (iii) Increases in other reserves. The positive amount with respect 
to reserves other than discounted unpaid

[[Page 151]]

loss reserves is the net increase of those reserves due to changes in 
estimate, methodology, or other assumptions used to compute the reserves 
(including the adoption by new target of a methodology or assumptions 
different from those used by old target).
    (4) Limitation on additional premium. The additional premium taken 
into account by new target under paragraph (d)(1) of this section is 
limited to the excess, if any, of--
    (i) The fair market value of old target's assets acquired by new 
target in the deemed asset sale (other than Class VI and Class VII 
assets); over
    (ii) The AGUB allocated to those assets (including increases in AGUB 
allocated to those assets as the result of reserve increases by new 
target in prior taxable years).
    (5) Treatment of additional premium under section 848. If a portion 
of the positive amounts described in paragraphs (d)(3)(ii) and (iii) of 
this section are attributable to an increase in reserves for specified 
insurance contracts (as defined in section 848(e)), new target takes an 
allocable portion of the additional premium in determining its specified 
policy acquisition expenses under section 848(c) for the taxable year of 
the reserve increase.
    (6) Examples. The following examples illustrate this paragraph (d):

    Example 1. (i) Facts. On January 1, 2006, P purchases all of the 
stock of T, a non-life insurance company, for $120 and makes a section 
338 election for T. On the acquisition date, old T has total reserve 
liabilities under state law of $725, consisting of undiscounted unpaid 
losses of $625 and unearned premiums of $100. Old T's tax reserves on 
the acquisition date are $580, which consist of discounted unpaid losses 
(as defined in section 846) of $500 and unearned premiums (as computed 
under section 832(b)(4)(B)) of $80. Old T has Class I through Class V 
assets with a fair market value of $800. Old T also has a Class VI asset 
with a fair market value of $75, consisting of the future profit stream 
of certain insurance contracts. During 2006, new T makes loss and loss 
adjustment expense payments of $200 with respect to the unpaid losses 
incurred by old T before the acquisition date. As of December 31, 2006, 
new T reports undiscounted unpaid losses of $475 attributable to losses 
incurred before the acquisition date. The related amount of discounted 
unpaid losses (as defined in section 846) for those losses is $390.
    (ii) Computation and allocation of AGUB. Under Sec. 1.338-5 and 
paragraph (b)(1) of this section, as of the acquisition date, AGUB is 
$700, reflecting the sum of the amount paid for old T's stock ($120) and 
the tax reserves assumed by new T in the transaction ($580). The fair 
market value of old T's Class I through V assets is $800, whereas the 
AGUB available for such assets under Sec. 1.338-6 is $700. There is no 
AGUB available for old T's Class VI assets, even though such assets have 
a fair market value of $75 on the acquisition date.
    (iii) Adjustments for increases in reserves for unpaid losses. Under 
paragraph (d) of this section, new T must determine whether there are 
any amounts by which it increased its unpaid loss reserves that will be 
treated as an additional premium and an increase in AGUB. New T applies 
the formula of paragraph (d)(3) of this section, where A equals $500, B 
equals $625, C equals $475, D equals $425 ($625 - $200), and E equals 
$0. Under this formula, new T is treated as having increased its 
reserves for discounted unpaid losses attributable to losses incurred by 
old T by $40 ($500/$625 x ($475 - [$425 + 0]). The limitation under 
paragraph (d)(5) of this section based on the difference between the 
fair market value of old T's Class I through Class V assets and the AGUB 
allocated to such assets is $100. Accordingly, new T includes an 
additional premium of $40 in gross income for 2006, and increases the 
AGUB allocated to old T's Class I through Class V assets to reflect this 
additional premium.
    Example 2. (i) Facts. Assume the same facts as in Example 1. Further 
assume that during 2007 new T deducts total loss and loss expense 
payments of $375 with respect to losses incurred by old T before the 
acquisition date. On December 31, 2007, new T reports undiscounted 
unpaid losses of $150 with respect to losses incurred before the 
acquisition date. The related amount of discounted unpaid losses (as 
defined in section 846) for those unpaid losses is $125.
    (ii) Analysis. New T must determine whether any amounts by which it 
increased its unpaid losses during 2007 will be treated as an additional 
premium in paragraph (d)(3) of this section. New T applies the formula 
under paragraph (d)(3) of this section, where A equals $500, B equals 
$625, C equals $150, D equals $50 ($625 - $575), and E equals $50 ($40 
divided by .8). In paragraph (d)(3) of this section, new T is treated as 
increasing its reserves for discounted unpaid losses by $40 during 2007 
with respect to losses incurred by old T ($500/$625 x ($150-[$50 + 
$50]). New T determines the limitation of paragraph (d)(5) of this 
section by comparing the $800 fair market value of the Class I through V 
assets on the acquisition date to the $740 AGUB allocated to such assets 
(which includes the $40 addition to AGUB included during 2006).

[[Page 152]]

Thus, new T recognizes $40 of additional premium as a result of the 
increase in reserves during 2007, and adjusts the AGUB allocable to the 
Class I through V assets acquired from old T to reflect such additional 
premium.

    Example 3. (i) Facts. The facts are the same as Example 2, except 
that on January 1, 2008, new T reinsures the outstanding liability with 
respect to losses incurred by old T before the acquisition date through 
a portfolio reinsurance transaction with R, another non-life insurance 
company. R agrees to assume any remaining liability relating to losses 
incurred by old T before the acquisition date in exchange for a 
reinsurance premium of $200. Accordingly, as of December 31, 2008, new T 
reports no undiscounted unpaid losses with respect to losses incurred by 
old T before the acquisition date.
    (ii) Analysis. New T must determine whether any amount by which it 
increased its unpaid loss reserves will be treated as an additional 
premium under paragraph (d) of this section. New T applies the formula 
of paragraph (d)(3) of this section, where A equals $500, B equals $625, 
C equals $0, and D equals -$150 ($625 - ($575 + $200), and E equals $100 
($80 divided by .8). Thus, new T is treated as having increased its 
discounted unpaid losses by $40 in 2008 with respect to losses incurred 
by old T before the acquisition date ($500/$625 x (0 -[-$150 + $100]). 
New T includes this positive amount in gross income, subject to the 
limitation of paragraph (d)(4) of this section. The limitation of 
paragraph (d)(4) of this section equals $20, which is computed by 
comparing the $800 fair market value of the Class I through V assets 
acquired from old T with the $780 AGUB allocated to such assets (which 
includes the $40 addition to AGUB in 2006 and the $40 addition to AGUB 
in 2007). Thus, New T includes $20 in additional premium, and increases 
the AGUB allocated to the Class I through V assets acquired from old T 
by $20. As a result of these adjustments, the limitation under paragraph 
(d)(4) of this section is reduced to zero.

    (7) Effective/applicability date--(i) In general. This section 
applies to increases to reserves made by new target after a deemed asset 
sale occurring on or after April 10, 2006.
    (ii) Application to pre-effective date increases to reserves. If 
either new target makes an election under Sec. 1.338(i)-1(c)(2) or old 
target makes an election under Sec. 1.338(i)-1(c)(3) to apply the rules 
of this section, in whole, to a qualified stock purchase occurring 
before April 10, 2006, then the rules contained in this section shall 
apply in whole to the qualified stock purchase.
    (e) Effect of section 338 election on section 846(e) election--(1) 
In general. New target and old target are treated as the same 
corporation for purposes of an election by old target to use its 
historical loss payment pattern under section 846(e). See Sec. 1.338-
1(b)(2)(vii). Therefore, if old target has a section 846(e) election in 
effect on the acquisition date, new target will continue to use the 
historical loss payment pattern of old target to discount unpaid losses 
incurred in accident years covered by the election, unless new target 
elects to revoke the section 846(e) election. In addition, new target 
may consider old target's historical loss payment pattern when 
determining whether to make the section 846(e) election for a 
determination year that includes or is subsequent to the acquisition 
date.
    (2) Revocation of existing section 846(e) election. New target may 
revoke old target's section 846(e) election to use its historical loss 
payment pattern to discount unpaid losses. If new target elects to 
revoke old target's section 846(e) election, new target will use the 
industry-wide patterns determined by the Secretary to discount unpaid 
losses incurred in accident years beginning on or after the acquisition 
date through the subsequent determination year. New target may revoke 
old target's section 846(e) election by attaching a statement to new 
target's original tax return for its first taxable year.
    (f) Effect of section 338 election on old target's capitalization 
amounts under section 848--(1) Determination of net consideration for 
specified insurance contracts. For purposes of applying section 848 and 
Sec. 1.848-2(f) to the deemed assumption reinsurance transaction, old 
target's net consideration (either positive or negative) for each 
category of specified insurance contracts is an amount equal to--
    (i) The allocable portion of the ceding commission (if any) relating 
to contracts in that category; less
    (ii) The amount by which old target's tax reserves for contracts in 
that category has been reduced as a result of the deemed assumption 
reinsurance transaction.
    (2) Determination of capitalization amount. Except as provided in 
Sec. 1.381(c)(22)-1(b)(13)--

[[Page 153]]

    (i) If, after the deemed asset sale, old target has an amount 
otherwise required to be capitalized under section 848 for the taxable 
year or an unamortized balance of specified policy acquisition expenses 
from prior taxable years, then old target deducts such remaining amount 
or unamortized balance as an expense incurred in the taxable year that 
includes the deemed sale tax consequences; and
    (ii) If, after the deemed asset sale, the negative capitalization 
amount resulting from the reinsurance transaction exceeds the amount 
that old target can deduct under section 848(f)(1), then old target's 
capitalization amount is treated as zero at the close of the taxable 
year that includes the deemed sale tax consequences.
    (3) Section 381 transactions. For transactions described in section 
381, see Sec. 1.381(c)(22)-1(b)(13).
    (g) Effect of section 338 election on policyholders surplus account. 
Except as specifically provided in Sec. 1.381(c)(22)-1(b)(7), the 
deemed asset sale effects a distribution of old target's policyholders 
surplus account to the extent the grossed-up amount realized on the sale 
to the purchasing corporation of the purchasing corporation's recently 
purchased target stock (as defined in Sec. 1.338-4(c)) exceeds old 
target's shareholders surplus account under section 815(c).
    (h) Effect of section 338 election on section 847 special estimated 
tax payments. If old target had elected to claim an additional deduction 
under section 847 for the taxable year that includes the deemed sale tax 
consequences or any earlier years, the amount remaining in old target's 
special loss discount account under section 847(3) must be reduced to 
the extent it relates to contracts transferred to new target and the 
amount of such reduction must be included in old target's gross income 
for the taxable year that includes the deemed sale tax consequences. Old 
target may apply the balance of its special estimated tax account as a 
credit against any tax resulting from such inclusion in gross income. 
Any special estimated tax payments remaining after this credit are 
voided and, therefore, are not available for credit or refund. Under 
section 847(1), new target is permitted to claim a section 847 deduction 
for losses incurred before the deemed asset sale, subject to the general 
requirement that new target makes timely special estimated tax payments 
equal to the tax benefit resulting from this deduction. See Sec. 
1.381(c)(22)-1(c)(14) regarding the carryover of the special loss 
discount account attributable to contracts transferred in a section 381 
transaction.

[T.D. 9257, 71 FR 18000, Apr. 10, 2006, as amended by T.D. 9377, 73 FR 
3872, Jan. 23, 2008]



Sec. 1.338(h)(10)-1  Deemed asset sale and liquidation.

    (a) Scope. This section prescribes rules for qualification for a 
section 338(h)(10) election and for making a section 338(h)(10) 
election. This section also prescribes the consequences of such 
election. The rules of this section are in addition to the rules of 
Sec. Sec. 1.338-1 through 1.338-10 and, in appropriate cases, apply 
instead of the rules of Sec. Sec. 1.338-1 through 1.338-10.
    (b) Definitions--(1) Consolidated target. A consolidated target is a 
target that is a member of a consolidated group within the meaning of 
Sec. 1.1502-1(h) on the acquisition date and is not the common parent 
of the group on that date.
    (2) Selling consolidated group. A selling consolidated group is the 
consolidated group of which the consolidated target is a member on the 
acquisition date.
    (3) Selling affiliate; affiliated target. A selling affiliate is a 
domestic corporation that owns on the acquisition date an amount of 
stock in a domestic target, which amount of stock is described in 
section 1504(a)(2), and does not join in filing a consolidated return 
with the target. In such case, the target is an affiliated target.
    (4) S corporation target. An S corporation target is a target that 
is an S corporation immediately before the acquisition date.
    (5) S corporation shareholders. S corporation shareholders are the S 
corporation target's shareholders. Unless otherwise indicated, a 
reference to S corporation shareholders refers both to S corporation 
shareholders who do and those who do not sell their target stock.

[[Page 154]]

    (6) Liquidation. Any reference in this section to a liquidation is 
treated as a reference to the transfer described in paragraph (d)(4) of 
this section notwithstanding its ultimate characterization for Federal 
income tax purposes.
    (c) Section 338(h)(10) election--(1) In general. A section 
338(h)(10) election may be made for T if P acquires stock meeting the 
requirements of section 1504(a)(2) from a selling consolidated group, a 
selling affiliate, or the S corporation shareholders in a qualified 
stock purchase.
    (2) Availability of section 338(h)(10) election in certain multi-
step transactions. Notwithstanding anything to the contrary in Sec. 
1.338-3(c)(1)(i), a section 338(h)(10) election may be made for T where 
P's acquisition of T stock, viewed independently, constitutes a 
qualified stock purchase and, after the stock acquisition, T merges or 
liquidates into P (or another member of the affiliated group that 
includes P), whether or not, under relevant provisions of law, including 
the step transaction doctrine, the acquisition of the T stock and the 
merger or liquidation of T qualify as a reorganization described in 
section 368(a). If a section 338(h)(10) election is made in a case where 
the acquisition of T stock followed by a merger or liquidation of T into 
P qualifies as a reorganization described in section 368(a), for all 
Federal tax purposes, P's acquisition of T stock is treated as a 
qualified stock purchase and is not treated as part of a reorganization 
described in section 368(a).
    (3) Simultaneous joint election requirement. A section 338(h)(10) 
election is made jointly by P and the selling consolidated group (or the 
selling affiliate or the S corporation shareholders) on Form 8023 in 
accordance with the instructions to the form. S corporation shareholders 
who do not sell their stock must also consent to the election. The 
section 338(h)(10) election must be made not later than the 15th day of 
the 9th month beginning after the month in which the acquisition date 
occurs.
    (4) Irrevocability. A section 338(h)(10) election is irrevocable. If 
a section 338(h)(10) election is made for T, a section 338 election is 
deemed made for T.
    (5) Effect of invalid election. If a section 338(h)(10) election for 
T is not valid, the section 338 election for T is also not valid.
    (d) Certain consequences of section 338(h)(10) election. For 
purposes of subtitle A of the Internal Revenue Code (except as provided 
in Sec. 1.338-1(b)(2)), the consequences to the parties of making a 
section 338(h)(10) election for T are as follows:
    (1) P. P is automatically deemed to have made a gain recognition 
election for its nonrecently purchased T stock, if any. The effect of a 
gain recognition election includes a taxable deemed sale by P on the 
acquisition date of any nonrecently purchased target stock. See Sec. 
1.338-5(d).
    (2) New T. The AGUB for new T's assets is determined under Sec. 
1.338-5 and is allocated among the acquisition date assets under 
Sec. Sec. 1.338-6 and 1.338-7. Notwithstanding paragraph (d)(4) of this 
section (deemed liquidation of old T), new T remains liable for the tax 
liabilities of old T (including the tax liability for the deemed sale 
tax consequences). For example, new T remains liable for the tax 
liabilities of the members of any consolidated group that are 
attributable to taxable years in which those corporations and old T 
joined in the same consolidated return. See Sec. 1.1502-6(a).
    (3) Old T--deemed sale--(i) In general. Old T is treated as 
transferring all of its assets to an unrelated person in exchange for 
consideration that includes the discharge of its liabilities in a single 
transaction at the close of the acquisition date (but before the deemed 
liquidation). See Sec. 1.338-1(a) regarding the tax characterization of 
the deemed asset sale. Except as provided in Sec. 1.338(h)(10)-1(d)(8) 
(regarding the installment method), old T recognizes all of the gain 
realized on the deemed transfer of its assets in consideration for the 
ADSP. ADSP for old T is determined under Sec. 1.338-4 and allocated 
among the acquisition date assets under Sec. Sec. 1.338-6 and 1.338-7. 
Old T realizes the deemed sale tax consequences from the deemed asset 
sale before the close of the acquisition date while old T is a member of 
the selling consolidated group (or owned by the selling affiliate or 
owned by the S corporation

[[Page 155]]

shareholders). If T is an affiliated target, or an S corporation target, 
the principles of Sec. Sec. 1.338-2(c)(10) and 1.338-10(a)(1), (5), and 
(6)(i) apply to the return on which the deemed sale tax consequences are 
reported. When T is an S corporation target, T's S election continues in 
effect through the close of the acquisition date (including the time of 
the deemed asset sale and the deemed liquidation) notwithstanding 
section 1362(d)(2)(B). Also, when T is an S corporation target (but not 
a qualified subchapter S subsidiary), any direct and indirect 
subsidiaries of T which T has elected to treat as qualified subchapter S 
subsidiaries under section 1361(b)(3) remain qualified subchapter S 
subsidiaries through the close of the acquisition date.
    (ii) Tiered targets. In the case of parent-subsidiary chains of 
corporations making elections under section 338(h)(10), the deemed asset 
sale of a parent corporation is considered to precede that of its 
subsidiary. See Sec. 1.338-3(b)(4)(i).
    (4) Old T and selling consolidated group, selling affiliate, or S 
corporation shareholders--deemed liquidation; tax characterization--(i) 
In general. Old T is treated as if, before the close of the acquisition 
date, after the deemed asset sale in paragraph (d)(3) of this section, 
and while old T is a member of the selling consolidated group (or owned 
by the selling affiliate or owned by the S corporation shareholders), it 
transferred all of its assets to members of the selling consolidated 
group, the selling affiliate, or S corporation shareholders and ceased 
to exist. The transfer from old T is characterized for Federal income 
tax purposes in the same manner as if the parties had actually engaged 
in the transactions deemed to occur because of this section and taking 
into account other transactions that actually occurred or are deemed to 
occur. For example, the transfer may be treated as a distribution in 
pursuance of a plan of reorganization, a distribution in complete 
cancellation or redemption of all its stock, one of a series of 
distributions in complete cancellation or redemption of all its stock in 
accordance with a plan of liquidation, or part of a circular flow of 
cash. In most cases, the transfer will be treated as a distribution in 
complete liquidation to which section 336 or 337 applies.
    (ii) Tiered targets. In the case of parent-subsidiary chains of 
corporations making elections under section 338(h)(10), the deemed 
liquidation of a subsidiary corporation is considered to precede the 
deemed liquidation of its parent.
    (5) Selling consolidated group, selling affiliate, or S corporation 
shareholders--(i) In general. If T is an S corporation target, S 
corporation shareholders (whether or not they sell their stock) take 
their pro rata share of the deemed sale tax consequences into account 
under section 1366 and increase or decrease their basis in T stock under 
section 1367. Members of the selling consolidated group, the selling 
affiliate, or S corporation shareholders are treated as if, after the 
deemed asset sale in paragraph (d)(3) of this section and before the 
close of the acquisition date, they received the assets transferred by 
old T in the transaction described in paragraph (d)(4)(i) of this 
section. In most cases, the transfer will be treated as a distribution 
in complete liquidation to which section 331 or 332 applies.
    (ii) Basis and holding period of T stock not acquired. A member of 
the selling consolidated group (or the selling affiliate or an S 
corporation shareholder) retaining T stock is treated as acquiring the 
stock so retained on the day after the acquisition date for its fair 
market value. The holding period for the retained stock starts on the 
day after the acquisition date. For purposes of this paragraph, the fair 
market value of all of the T stock equals the grossed-up amount realized 
on the sale to P of P's recently purchased target stock. See Sec. 
1.338-4(c).
    (iii) T stock sale. Members of the selling consolidated group (or 
the selling affiliate or S corporation shareholders) recognize no gain 
or loss on the sale or exchange of T stock included in the qualified 
stock purchase (although they may recognize gain or loss on the T stock 
in the deemed liquidation).
    (6) Nonselling minority shareholders other than nonselling S 
corporation shareholders--(i) In general. This paragraph (d)(6) 
describes the treatment of shareholders of old T other than the

[[Page 156]]

following: Members of the selling consolidated group, the selling 
affiliate, S corporation shareholders (whether or not they sell their 
stock), and P. For a description of the treatment of S corporation 
shareholders, see paragraph (d)(5) of this section. A shareholder to 
which this paragraph (d)(6) applies is called a minority shareholder.
    (ii) T stock sale. A minority shareholder recognizes gain or loss on 
the shareholder's sale or exchange of T stock included in the qualified 
stock purchase.
    (iii) T stock not acquired. A minority shareholder does not 
recognize gain or loss under this section with respect to shares of T 
stock retained by the shareholder. The shareholder's basis and holding 
period for that T stock is not affected by the section 338(h)(10) 
election.
    (7) Consolidated return of selling consolidated group. If P acquires 
T in a qualified stock purchase from a selling consolidated group--
    (i) The selling consolidated group must file a consolidated return 
for the taxable period that includes the acquisition date;
    (ii) A consolidated return for the selling consolidated group for 
that period may not be withdrawn on or after the day that a section 
338(h)(10) election is made for T; and
    (iii) Permission to discontinue filing consolidated returns cannot 
be granted for, and cannot apply to, that period or any of the 
immediately preceding taxable periods during which consolidated returns 
continuously have been filed.
    (8) Availability of the section 453 installment method. Solely for 
purposes of applying sections 453, 453A, and 453B, and the regulations 
thereunder (the installment method) to determine the consequences to old 
T in the deemed asset sale and to old T (and its shareholders, if 
relevant) in the deemed liquidation, the rules in paragraphs (d)(1) 
through (7) of this section are modified as follows:
    (i) In deemed asset sale. Old T is treated as receiving in the 
deemed asset sale new T installment obligations, the terms of which are 
identical (except as to the obligor) to P installment obligations issued 
in exchange for recently purchased stock of T. Old T is treated as 
receiving in cash all other consideration in the deemed asset sale other 
than the assumption of, or taking subject to, old T liabilities. For 
example, old T is treated as receiving in cash any amounts attributable 
to the grossing-up of amount realized under Sec. 1.338-4(c). The amount 
realized for recently purchased stock taken into account in determining 
ADSP is adjusted (and, thus, ADSP is redetermined) to reflect the 
amounts paid under an installment obligation for the stock when the 
total payments under the installment obligation are greater or less than 
the amount realized.
    (ii) In deemed liquidation. Old T is treated as distributing in the 
deemed liquidation the new T installment obligations that it is treated 
as receiving in the deemed asset sale. The members of the selling 
consolidated group, the selling affiliate, or the S corporation 
shareholders are treated as receiving in the deemed liquidation the new 
T installment obligations that correspond to the P installment 
obligations they actually received individually in exchange for their 
recently purchased stock. The new T installment obligations may be 
recharacterized under other rules. See for example Sec. 1.453-11(a)(2) 
which, in certain circumstances, treats the new T installment 
obligations deemed distributed by old T as if they were issued by new T 
in exchange for the stock in old T owned by members of the selling 
consolidated group, the selling affiliate, or the S corporation 
shareholders. The members of the selling consolidated group, the selling 
affiliate, or the S corporation shareholders are treated as receiving 
all other consideration in the deemed liquidation in cash.
    (9) Treatment consistent with an actual asset sale. No provision in 
section 338(h)(10) or this section shall produce a Federal income tax 
result under subtitle A of the Internal Revenue Code that would not 
occur if the parties had actually engaged in the transactions deemed to 
occur because of this section and taking into account other transactions 
that actually occurred or are deemed to occur. See, however, Sec. 
1.338-1(b)(2) for certain exceptions to this rule.

[[Page 157]]

    (e) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. (i) S1 owns all of the T stock and T owns all of the 
stock of T1 and T2. S1 is the common parent of a consolidated group that 
includes T, T1, and T2. P makes a qualified stock purchase of all of the 
T stock from S1. S1 joins with P in making a section 338(h)(10) election 
for T and for the deemed purchase of T1. A section 338 election is not 
made for T2.
    (ii) S1 does not recognize gain or loss on the sale of the T stock 
and T does not recognize gain or loss on the sale of the T1 stock 
because section 338(h)(10) elections are made for T and T1. Thus, for 
example, gain or loss realized on the sale of the T or T1 stock is not 
taken into account in earnings and profits. However, because a section 
338 election is not made for T2, T must recognize any gain or loss 
realized on the deemed sale of the T2 stock. See Sec. 1.338-4(h).
    (iii) The results would be the same if S1, T, T1, and T2 are not 
members of any consolidated group, because S1 and T are selling 
affiliates.
    Example 2. (i) S and T are solvent corporations. S owns all of the 
outstanding stock of T. S and P agree to undertake the following 
transaction: T will distribute half its assets to S, and S will assume 
half of T's liabilities. Then, P will purchase the stock of T from S. S 
and P will jointly make a section 338(h)(10) election with respect to 
the sale of T. The corporations then complete the transaction as agreed.
    (ii) Under section 338(a), the assets present in T at the close of 
the acquisition date are deemed sold by old T to new T. Under paragraph 
(d)(4) of this section, the transactions described in paragraph (d) of 
this section are treated in the same manner as if they had actually 
occurred. Because S and P had agreed that, after T's actual distribution 
to S of part of its assets, S would sell T to P pursuant to an election 
under section 338(h)(10), and because paragraph (d)(4) of this section 
deems T subsequently to have transferred all its assets to its 
shareholder, T is deemed to have adopted a plan of complete liquidation 
under section 332. T's actual transfer of assets to S is treated as a 
distribution pursuant to that plan of complete liquidation.
    Example 3. (i) S1 owns all of the outstanding stock of both T and 
S2. All three are corporations. S1 and P agree to undertake the 
following transaction. T will transfer substantially all of its assets 
and liabilities to S2, with S2 issuing no stock in exchange therefor, 
and retaining its other assets and liabilities. Then, P will purchase 
the stock of T from S1. S1 and P will jointly make a section 338(h)(10) 
election with respect to the sale of T. The corporations then complete 
the transaction as agreed.
    (ii) Under section 338(a), the remaining assets present in T at the 
close of the acquisition date are deemed sold by old T to new T. Under 
paragraph (d)(4) of this section, the transactions described in this 
section are treated in the same manner as if they had actually occurred. 
Because old T transferred substantially all of its assets to S2, and is 
deemed to have distributed all its remaining assets and gone out of 
existence, the transfer of assets to S2, taking into account the related 
transfers, deemed and actual, qualifies as a reorganization under 
section 368(a)(1)(D). Section 361(c)(1) and not section 332 applies to 
T's deemed liquidation.
    Example 4. (i) T owns two assets: an actively traded security (Class 
II) with a fair market value of $100 and an adjusted basis of $100, and 
inventory (Class IV) with a fair market value of $100 and an adjusted 
basis of $100. T has no liabilities. S is negotiating to sell all the 
stock in T to P for $100 cash and contingent consideration. Assume that 
under generally applicable tax accounting rules, P's adjusted basis in 
the T stock immediately after the purchase would be $100, because the 
contingent consideration is not taken into account. Thus, under the 
rules of Sec. 1.338-5, AGUB would be $100. Under the allocation rules 
of Sec. 1.338-6, the entire $100 would be allocated to the Class II 
asset, the actively traded security, and no amount would be allocated to 
the inventory. P, however, plans immediately to cause T to sell the 
inventory, but not the actively traded security, so it requests that, 
prior to the stock sale, S cause T to create a new subsidiary, Newco, 
and contribute the actively traded security to the capital of Newco. 
Because the stock in Newco, which would not be actively traded, is a 
Class V asset, under the rules of Sec. 1.338-6 $100 of AGUB would be 
allocated to the inventory and no amount of AGUB would be allocated to 
the Newco stock. Newco's own AGUB, $0 under the rules of Sec. 1.338-5, 
would be allocated to the actively traded security. When P subsequently 
causes T to sell the inventory, T would realize no gain or loss instead 
of realizing gain of $100.
    (ii) Assume that, if the T stock had not itself been sold but T had 
instead sold both its inventory and the Newco stock to P, T would for 
tax purposes be deemed instead to have sold both its inventory and 
actively traded security directly to P, with P deemed then to have 
created Newco and contributed the actively traded security to the 
capital of Newco. Section 338, if elected, generally recharacterizes a 
stock sale as a deemed sale of assets. However, paragraph (d)(9) of this 
section states, in general, that no provision of section 338(h)(10) or 
the regulations thereunder shall produce a Federal income tax result 
under subtitle A of the Internal Revenue Code that would not occur if 
the parties had

[[Page 158]]

actually engaged in the transactions deemed to occur by virtue of the 
section 338(h)(10) election, taking into account other transactions that 
actually occurred or are deemed to occur. Hence, the deemed sale of 
assets under section 338(h)(10) should be treated as one of the 
inventory and actively traded security themselves, not of the inventory 
and Newco stock. The anti-abuse rule of Sec. 1.338-1(c) does not apply, 
because the substance of the deemed sale of assets is a sale of the 
inventory and the actively traded security themselves, not of the 
inventory and the Newco stock. Otherwise, the anti-abuse rule might 
apply.
    Example 5. (i) T, a member of a selling consolidated group, has only 
one class of stock, all of which is owned by S1. On March 1 of Year 2, 
S1 sells its T stock to P for $80,000, and joins with P in making a 
section 338(h)(10) election for T. There are no selling costs or 
acquisition costs. On March 1 of Year 2, T owns land with a $50,000 
basis and $75,000 fair market value and equipment with a $30,000 
adjusted basis, $70,000 recomputed basis, and $60,000 fair market value. 
T also has a $40,000 liability. S1 pays old T's allocable share of the 
selling group's consolidated tax liability for Year 2 including the tax 
liability for the deemed sale tax consequences (a total of $13,600).
    (ii) ADSP of $120,000 ($80,000 + $40,000 + 0) is allocated to each 
asset as follows:

----------------------------------------------------------------------------------------------------------------
                 Assets                         Basis              FMV            Fraction       Allocable ADSP
----------------------------------------------------------------------------------------------------------------
Land....................................           $50,000           $75,000             \5/9\           $66,667
Equipment...............................            30,000            60,000             \4/9\            53,333
                                         -----------------------------------------------------------------------
      Total.............................            80,000           135,000                 1           120,000
----------------------------------------------------------------------------------------------------------------

    (iii) Under paragraph (d)(3) of this section, old T has gain on the 
deemed sale of $40,000 (consisting of $16,667 of capital gain and 
$23,333 of ordinary income).
    (iv) Under paragraph (d)(5)(iii) of this section, S1 recognizes no 
gain or loss upon its sale of the old T stock to P. S1 also recognizes 
no gain or loss upon the deemed liquidation of T. See paragraph (d)(4) 
of this section and section 332.
    (v) P's basis in new T stock is P's cost for the stock, $80,000. See 
section 1012.
    (vi) Under Sec. 1.338-5, the AGUB for new T is $120,000, i.e., P's 
cost for the old T stock ($80,000) plus T's liability ($40,000). This 
AGUB is allocated as basis among the new T assets under Sec. Sec. 
1.338-6 and 1.338-7.
    Example 6. (i) The facts are the same as in Example 5, except that 
S1 sells 80 percent of the old T stock to P for $64,000, rather than 100 
percent of the old T stock for $80,000.
    (ii) The consequences to P, T, and S1 are the same as in Example 5, 
except that:
    (A) P's basis for its 80-percent interest in the new T stock is P's 
$64,000 cost for the stock. See section 1012.
    (B) Under Sec. 1.338-5, the AGUB for new T is $120,000 (i.e., 
$64,000/.8 + $40,000 + $0).
    (C) Under paragraph (d)(4) of this section, S1 recognizes no gain or 
loss with respect to the retained stock in T. See section 332.
    (D) Under paragraph (d)(5)(ii) of this section, the basis of the T 
stock retained by S1 is $16,000 (i.e., $120,000 - $40,000 (the ADSP 
amount for the old T assets over the sum of new T's liabilities 
immediately after the acquisition date) `` .20 (the proportion of T 
stock retained by S1)).
    Example 7. (i) The facts are the same as in Example 6, except that 
K, a shareholder unrelated to T or P, owns the 20 percent of the T stock 
that is not acquired by P in the qualified stock purchase. K's basis in 
its T stock is $5,000.
    (ii) The consequences to P, T, and S1 are the same as in Example 6.
    (iii) Under paragraph (d)(6)(iii) of this section, K recognizes no 
gain or loss, and K's basis in its T stock remains at $5,000.
    Example 8. (i) The facts are the same as in Example 5, except that 
the equipment is held by T1, a wholly-owned subsidiary of T, and a 
section 338(h)(10) election is also made for T1. The T1 stock has a fair 
market value of $60,000. T1 has no assets other than the equipment and 
no liabilities. S1 pays old T's and old T1's allocable shares of the 
selling group's consolidated tax liability for Year 2 including the tax 
liability for T and T1's deemed sale tax consequences.
    (ii) ADSP for T is $120,000, allocated $66,667 to the land and 
$53,333 to the stock. Old T's deemed sale results in $16,667 of capital 
gain on its deemed sale of the land. Under paragraph (d)(5)(iii) of this 
section, old T does not recognize gain or loss on its deemed sale of the 
T1 stock. See section 332.
    (iii) ADSP for T1 is $53,333 (i.e., $53,333 + $0 + $0). On the 
deemed sale of the equipment, T1 recognizes ordinary income of $23,333.
    (iv) Under paragraph (d)(5)(iii) of this section, S1 does not 
recognize gain or loss upon its sale of the old T stock to P.
    Example 9. (i) The facts are the same as in Example 8, except that P 
already owns 20 percent of the T stock, which is nonrecently purchased 
stock with a basis of $6,000, and that P purchases the remaining 80 
percent of the T stock from S1 for $64,000.
    (ii) The results are the same as in Example 8, except that under 
paragraph (d)(1) of this section and Sec. 1.338-5(d), P is deemed to 
have

[[Page 159]]

made a gain recognition election for its nonrecently purchased T stock. 
As a result, P recognizes gain of $10,000 and its basis in the 
nonrecently purchased T stock is increased from $6,000 to $16,000. P's 
basis in all the T stock is $80,000 (i.e., $64,000 + $16,000). The 
computations are as follows:
    (A) P's grossed-up basis for the recently purchased T stock is 
$64,000 (i.e., $64,000 (the basis of the recently purchased T stock) x 
(1-.2)/(.8) (the fraction in section 338(b)(4))).
    (B) P's basis amount for the nonrecently purchased T stock is 
$16,000 (i.e., $64,000 (the grossed-up basis in the recently purchased T 
stock) x (.2)/(1.0-.2) (the fraction in section 338(b)(3)(B))).
    (C) The gain recognized on the nonrecently purchased stock is 
$10,000 (i.e., $16,000-$6,000).
    Example 10. (i) T is an S corporation whose sole class of stock is 
owned 40 percent each by A and B and 20 percent by C. T, A, B, and C all 
use the cash method of accounting. A and B each has an adjusted basis of 
$10,000 in the stock. C has an adjusted basis of $5,000 in the stock. A, 
B, and C hold no installment obligations to which section 453A applies. 
On March 1 of Year 1, A sells its stock to P for $40,000 in cash and B 
sells its stock to P for a $25,000 note issued by P and real estate 
having a fair market value of $15,000. The $25,000 note, due in full in 
Year 7, is not publicly traded and bears adequate stated interest. A and 
B have no selling expenses. T's sole asset is real estate, which has a 
value of $110,000 and an adjusted basis of $35,000. Also, T's real 
estate is encumbered by long-outstanding purchase-money indebtedness of 
$10,000. The real estate does not have built-in gain subject to section 
1374. A, B, and C join with P in making a section 338(h)(10) election 
for T.
    (ii) Solely for purposes of application of sections 453, 453A, and 
453B, old T is considered in its deemed asset sale to receive back from 
new T the $25,000 note (considered issued by new T) and $75,000 of cash 
(total consideration of $80,000 paid for all the stock sold, which is 
then divided by .80 in the grossing-up, with the resulting figure of 
$100,000 then reduced by the amount of the installment note). Absent an 
election under section 453(d), gain is reported by old T under the 
installment method.
    (iii) In applying the installment method to old T's deemed asset 
sale, the contract price for old T's assets deemed sold is $100,000, the 
$110,000 selling price reduced by the indebtedness of $10,000 to which 
the assets are subject. (The $110,000 selling price is itself the sum of 
the $80,000 grossed-up in paragraph (ii) above to $100,000 and the 
$10,000 liability.) Gross profit is $75,000 ($110,000 selling price - 
old T's basis of $35,000). Old T's gross profit ratio is 0.75 (gross 
profit of $75,000 / $100,000 contract price). Thus, $56,250 (0.75 x the 
$75,000 cash old T is deemed to receive in Year 1) is Year 1 gain 
attributable to the sale, and $18,750 ($75,000 - $56,250) is recovery of 
basis.
    (iv) In its liquidation, old T is deemed to distribute the $25,000 
note to B, since B actually sold the stock partly for that 
consideration. To the extent of the remaining liquidating distribution 
to B, it is deemed to receive, along with A and C, the balance of old 
T's liquidating assets in the form of cash. Under section 453(h), B, 
unless it makes an election under section 453(d), is not required to 
treat the receipt of the note as a payment for the T stock; P's payment 
of the $25,000 note in Year 7 to B is a payment for the T stock. Because 
section 453(h) applies to B, old T's deemed liquidating distribution of 
the note is, under section 453B(h), not treated as a taxable disposition 
by old T.
    (v) Under section 1366, A reports 40 percent, or $22,500, of old T's 
$56,250 gain recognized in Year 1. Under section 1367, this increases 
A's $10,000 adjusted basis in the T stock to $32,500. Next, in old T's 
deemed liquidation, A is considered to receive $40,000 for its old T 
shares, causing it to recognize an additional $7,500 gain in Year 1.
    (vi) Under section 1366, B reports 40 percent, or $22,500, of old 
T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases B's $10,000 adjusted basis in its T stock to $32,500. Next, in 
old T's deemed liquidation, B is considered to receive the $25,000 note 
and $15,000 of other consideration. Applying section 453, including 
section 453(h), to the deemed liquidation, B's selling price and 
contract price are both $40,000. Gross profit is $7,500 ($40,000 selling 
price - B's basis of $32,500). B's gross profit ratio is 0.1875 (gross 
profit of $7,500 / $40,000 contract price). Thus, $2,812.50 (0.1875 x 
$15,000) is Year 1 gain attributable to the deemed liquidation. In Year 
7, when the $25,000 note is paid, B has $4,687.50 (0.1875 x $25,000) of 
additional gain.
    (vii) Under section 1366, C reports 20 percent, or $11,250, of old 
T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases C's $5,000 adjusted basis in its T stock to $16,250. Next, in 
old T's deemed liquidation, C is considered to receive $20,000 for its 
old T shares, causing it to recognize an additional $3,750 gain in Year 
1. Finally, under paragraph (d)(5)(ii) of this section, C is considered 
to acquire its stock in T on the day after the acquisition date for 
$20,000 (fair market value = grossed-up amount realized of $100,000 x 
20%). C's holding period in the stock deemed received in new T begins at 
that time.
    Example 11. Stock acquisition followed by upstream merger--without 
section 338(h)(10) election. (i) P owns all the stock of Y, a newly 
formed subsidiary. S owns all the stock of T. Each of P, S, T and Y is a 
domestic corporation. P acquires all of the T stock in a statutory 
merger of Y into T, with T surviving. In

[[Page 160]]

the merger, S receives consideration consisting of 50% P voting stock 
and 50% cash. Viewed independently of any other step, P's acquisition of 
T stock constitutes a qualified stock purchase. As part of the plan that 
includes P's acquisition of the T stock, T subsequently merges into P. 
Viewed independently of any other step, T's merger into P qualifies as a 
liquidation described in section 332. Absent the application of 
paragraph (c)(2) of this section, the step transaction doctrine would 
apply to treat P's acquisition of the T stock and T's merger into P as 
an acquisition by P of T's assets in a reorganization described in 
section 368(a). P and S do not make a section 338(h)(10) election with 
respect to P's purchase of the T stock.
    (ii) Because P and S do not make an election under section 
338(h)(10) for T, P's acquisition of the T stock and T's merger into P 
is treated as part of a reorganization described in section 368(a).
    Example 12. Stock acquisition followed by upstream merger--with 
section 338(h)(10) election. (i) The facts are the same as in Example 11 
except that P and S make a joint election under section 338(h)(10) for 
T.
    (ii) Pursuant to paragraph (c)(2) of this section, as a result of 
the election under section 338(h)(10), for all Federal tax purposes, P's 
acquisition of the T stock is treated as a qualified stock purchase and 
P's acquisition of the T stock is not treated as part of a 
reorganization described in section 368(a).
    Example 13. Stock acquisition followed by brother-sister merger--
with section 338(h)(10) election. (i) The facts are the same as in 
Example 12, except that, following P's acquisition of the T stock, T 
merges into X, a domestic corporation that is a wholly owned subsidiary 
of P. Viewed independently of any other step, T's merger into X 
qualifies as a reorganization described in section 368(a). Absent the 
application of paragraph (c)(2) of this section, the step transaction 
doctrine would apply to treat P's acquisition of the T stock and T's 
merger into X as an acquisition by X of T's assets in a reorganization 
described in section 368(a).
    (ii) Pursuant to paragraph (c)(2) of this section, as a result of 
the election under section 338(h)(10), for all Federal tax purposes, P's 
acquisition of T stock is treated as a qualified stock purchase and P's 
acquisition of T stock is not treated as part of a reorganization 
described in section 368(a).
    Example 14. Stock acquisition that does not qualify as a qualified 
stock purchase followed by upstream merger. (i) The facts are the same 
as in Example 11, except that, in the statutory merger of Y into T, S 
receives only P voting stock.
    (ii) Pursuant to Sec. 1.338-3(c)(1)(i) and paragraph (c)(2) of this 
section, no election under section 338(h)(10) can be made with respect 
to P's acquisition of the T stock because, pursuant to relevant 
provisions of law, including the step transaction doctrine, that 
acquisition followed by T's merger into P is treated as a reorganization 
described in section 368(a)(1)(A), and that acquisition, viewed 
independently of T's merger into P, does not constitute a qualified 
stock purchase under section 338(d)(3). Accordingly, P's acquisition of 
the T stock and T's merger into P is treated as a reorganization 
described in section 368(a).

    (f) Inapplicability of provisions. The provisions of section 6043, 
Sec. Sec. 1.331-1(d) and 1.332-6 (relating to information returns and 
recordkeeping requirements for corporate liquidations) do not apply to 
the deemed liquidation of old T under paragraph (d)(4) of this section.
    (g) Required information. The Commissioner may exercise the 
authority granted in section 338(h)(10)(C)(iii) to require provision of 
any information deemed necessary to carry out the provisions of section 
338(h)(10) by requiring submission of information on any tax reporting 
form.
    (h) Effective date. This section is applicable to stock acquisitions 
occurring on or after July 5, 2006. For stock acquisitions occurring 
before July 5, 2006, see Sec. 1.338(h)(10)-1T as contained in the 
edition of 26 CFR part 1, revised as of April 1, 2006.

[T.D. 8940, 66 FR 8950, Feb. 13, 2001, as amended by T.D. 9071, 68 FR 
40768, July 9, 2003; T.D. 9264, 71 FR 30607, May 30, 2006; T.D. 9271, 71 
FR 38075, July 5, 2006; T.D. 9329, 72 FR 32808, June 14, 2007]



Sec. 1.338(i)-1  Effective/applicability date.

    (a) In general. The provisions of Sec. Sec. 1.338-1 through 1.338-
7, 1.338-10 and 1.338(h)(10)-1 apply to any qualified stock purchase 
occurring after March 15, 2001. For rules applicable to qualified stock 
purchases on or before March 15, 2001, see Sec. Sec. 1.338-1T through 
1.338-7T, 1.338-10T, 1.338(h)(10)-1T and 1.338(i)-1T in effect prior to 
March 16, 2001 (see 26 CFR part 1 revised April 1, 2000).
    (b) Section 338(h)(10) elections for S corporation targets. The 
requirements of Sec. Sec. 1.338(h)(10)-1T(c)(2) and 1.338(h)(10)-
1(c)(2) that S corporation shareholders who do not sell their stock must 
also consent to an election under section 338(h)(10) will not invalidate 
an otherwise valid election made on the September 1997 revision of Form 
8023,

[[Page 161]]

``Elections Under Section 338 For Corporations Making Qualified Stock 
Purchases,'' not signed by the nonselling shareholders, provided that 
the S corporation and all of its shareholders (including nonselling 
shareholders) report the tax consequences consistently with the results 
under section 338(h)(10).
    (c) Section 338 elections for insurance company targets--(1) In 
general. The rules of Sec. 1.338-11 apply to qualified stock purchases 
occurring on or after April 10, 2006.
    (2) New target election for retroactive application--(i) 
Availability of election. New target may make an irrevocable election to 
apply the rules in Sec. Sec. 1.338-11 (including the applicable 
provisions in Sec. Sec. 1.197-2(g)(5), 381(c)(22)-1, and 846) in whole, 
but not in part, to a qualified stock purchase occurring before April 
10, 2006 for which a section 338 election is made, provided that new 
target's first taxable year and all subsequent affected taxable years 
are years for which an assessment of deficiency or a refund for 
overpayment is not prevented by any law or rule of law. In the case of a 
section 338 election for which a section 338(h)(10) election is made (or 
a section 338 election for a foreign target), new target may make the 
election to apply the regulations retroactively without regard to 
whether old target makes the election. In the case of a section 338 
election for a domestic target for which no section 338(h)(10) election 
is made, new target may make the election to apply the regulations 
retroactively only if old target also makes the election. Paragraph 
(c)(2)(ii) of this section prescribes the time and manner of the 
election for new target.
    (ii) Time and manner of making the election for new target. New 
target may make an election described in paragraph (c)(2)(i) of this 
section by attaching a statement to its original or amended income tax 
return for its first taxable year. The statement must be entitled 
``Election to Retroactively Apply the Rules in Sec. Sec. 1.338-11 
(including the applicable provisions in Sec. Sec. 1.197-2(g)(5), 
1.381(c)(22)-1 and 846) in whole to a transaction completed before April 
10, 2006'' and must include the following information--
    (A) The name and E.I.N. for new target; and
    (B) The following declaration (or a substantially similar 
declaration): New target has amended its income tax returns for its 
first taxable year and for all affected subsequent years to reflect the 
rules in Sec. Sec. 1.338-11 (including the applicable provisions in 
Sec. Sec. 197-2(g)(5), 1.381(c)(22)-1 and 846). All other parties whose 
income tax liabilities are affected by new target's election have 
amended their income tax returns for all affected years to reflect the 
rules in Sec. Sec. 1.338-11 (including the applicable provisions in 
Sec. Sec. 1.197-2(g)(5), 1.381(c)(22)-1 and 846).
    (3) Old target election for retroactive application--(i) 
Availability of election. Old target may make an irrevocable election to 
apply the rules in Sec. Sec. 1.338-11 (including the applicable 
provisions in Sec. Sec. 1.197-2(g)(5), 1.381(c)(22)-1 and 846) in 
whole, but not in part, to a qualified stock purchase occurring before 
April 10, 2006 for which a section 338 election is made, provided that 
old target's taxable year that includes the deemed sale tax consequences 
and all subsequent affected taxable years are years for which an 
assessment of deficiency or a refund for overpayment is not prevented by 
any law or rule of law. In the case of a section 338 election for which 
a section 338(h)(10) election is made (or a section 338 election for a 
foreign target), old target may make the election to apply the 
regulations retroactively without regard to whether new target makes the 
election. In the case of a section 338 election for a domestic target 
for which no section 338(h)(10) election is made, old target may make 
the election to apply the regulations retroactively only if new target 
also makes the election. Paragraph (c)(3)(ii) of this section prescribes 
the time and manner of the election for old target.
    (ii) Time and manner of making the election for old target. Old 
target may make an election described in paragraph (c)(3)(i) of this 
section by attaching a statement to each affected party's original or 
amended income tax return for the taxable year that includes the deemed 
sale tax consequences. The statement must be entitled ``Election to 
Retroactively Apply the Rules in Sec. Sec. 1.338-11 (including the 
applicable provisions in Sec. Sec. 1.197-2(g)(5), 1.381(c)(22)-1

[[Page 162]]

and 846) to a transaction completed before April 10, 2006'' and must 
include the following information--
    (A) The name and E.I.N. for old target; and
    (B) The following declaration (or a substantially similar 
declaration): Old target has amended its income tax returns for the 
taxable year that includes the deemed sale tax consequences and for all 
affected subsequent years to reflect the rules in Sec. Sec. 1.338-11 
(including the applicable provisions in Sec. Sec. 1.197-2(g)(5), 
1.381(c)(22)-1 and 846). All other parties whose income tax liabilities 
are affected by old target's election have amended their income tax 
returns for all affected years to reflect the rules in Sec. Sec. 1.338-
11 (including the applicable provisions in Sec. Sec. 1.197-2(g)(5), 
1.381(c)(22)-1 and 846).

[T.D. 8940, 66 FR 9954, Feb. 13, 2001, as amended by T.D. 9257, 71 FR 
18003, Apr. 10, 2006; T.D. 9377, 73 FR 3873, 3874, Jan. 23, 2008]

      collapsible corporations; foreign personal holding companies



Sec. 1.341-1  Collapsible corporations; in general.

    Subject to the limitations contained in Sec. 1.341-4 and the 
exceptions contained in Sec. 1.341-6 and Sec. 1.341-7(a), the entire 
gain from the actual sale or exchange of stock of a collapsible 
corporation, (b) amounts distributed in complete or partial liquidation 
of a collapsible corporation which are treated, under section 331, as 
payment in exchange for stock, and (c) a distribution made by a 
collapsible corporation which, under section 301(c)(3), is treated, to 
the extent it exceeds the basis of the stock, in the same manner as a 
gain from the sale or exchange of property, shall be considered as 
ordinary income.

[T.D. 7655, 44 FR 68459, Nov. 29, 1979]



Sec. 1.341-2  Definitions.

    (a) Determination of collapsible corporation. (1) A collapsible 
corporation is defined by section 341(b)(1) to be a corporation formed 
or availed of principally (i) for the manufacture, construction, or 
production of property, (ii) for the purchase of property which (in the 
hands of the corporation) is property described in section 341(b)(3), or 
(iii) for the holding of stock in a corporation so formed or availed of, 
with a view to (a) the sale or exchange of stock by its shareholders 
(whether in liquidation or otherwise), or a distribution to its 
shareholders, prior to the realization by the corporation manufacturing, 
constructing, producing, or purchasing the property of a substantial 
part of the taxable income to be derived from such property, and (b) the 
realization by such shareholders of gain attributable to such property. 
See Sec. 1.341-5 for a description of the facts which will ordinarily 
be considered sufficient to establish whether or not a corporation is a 
collapsible corporation under the rules of this section. See paragraph 
(d) of Sec. 1.341-5 for examples of the application of section 341.
    (2) Under section 341(b)(1) the corporation must be formed or 
availed of with a view to the action therein described, that is, the 
sale or exchange of its stock by its shareholders, or a distribution to 
them prior to the realization by the corporation manufacturing, 
constructing, producing, or purchasing the property of a substantial 
part of the taxable income to be derived from such property, and the 
realization by the shareholders of gain attributable to such property. 
This requirement is satisfied in any case in which such action was 
contemplated by those persons in a position to determine the policies of 
the corporation, whether by reason of their owning a majority of the 
voting stock of the corporation or otherwise. The requirement is 
satisfied whether such action was contemplated, unconditionally, 
conditionally, or as a recognized possibility. If the corporation was so 
formed or availed of, it is immaterial that a particular shareholder was 
not a shareholder at the time of the manufacture, construction, 
production, or purchase of the property, or if a shareholder at such 
time, did not share in such view. Any gain of such a shareholder on his 
stock in the corporation shall be treated in the same manner as gain of 
a shareholder who did share in such view. The existence of a bona fide 
business reason for doing business in the corporate form does not, by 
itself, negate the fact that the corporation may also have been formed

[[Page 163]]

or availed of with a view to the action described in section 341(b).
    (3) A corporation is formed or availed of with a view to the action 
described in section 341(b) if the requisite view existed at any time 
during the manufacture, production, construction, or purchase referred 
to in that section. Thus, if the sale, exchange, or distribution is 
attributable solely to circumstances which arose after the manufacture, 
construction, production, or purchase (other than circumstances which 
reasonably could be anticipated at the time of such manufacture, 
construction, production, or purchase), the corporation shall, in the 
absence of compelling facts to the contrary, be considered not to have 
been so formed or availed of. However, if the sale, exchange or 
distribution is attributable to circumstances present at the time of the 
manufacture, construction, production, or purchase, the corporation 
shall, in the absence of compelling facts to the contrary, be considered 
to have been so formed or availed of.
    (4) The property referred to in section 341(b) is that property or 
the aggregate of those properties with respect to which the requisite 
view existed. In order to ascertain the property or properties as to 
which the requisite view existed, reference shall be made to each 
property as to which, at the time of the sale, exchange, or distribution 
referred to in section 341(b) there has not been a realization by the 
corporation manufacturing, constructing, producing, or purchasing the 
property of a substantial part of the taxable income to be derived from 
such property. However, where any such property is a unit of an 
integrated project involving several properties similar in kind, the 
determination whether the requisite view existed shall be made only if a 
substantial part of the taxable income to be derived from the project 
has not been realized at the time of the sale, exchange, or 
distribution, and in such case the determination shall be made by 
reference to the aggregate of the properties constituting the single 
project.
    (5) A corporation shall be deemed to have manufactured, constructed, 
produced, or purchased property if it (i) engaged in the manufacture, 
construction, or production of property to any extent, or (ii) holds 
property having a basis determined, in whole or in part, by reference to 
the cost of such property in the hands of a person who manufactured, 
constructed, produced, or purchased the property, or (iii) holds 
property having a basis determined, in whole or in part, by reference to 
the cost of property manufactured, constructed, produced, or purchased 
by the corporation. Thus, under subdivision (i) of this subparagraph, 
for example, a corporation need not have originated nor have completed 
the manufacture, construction, or production of the property. Under 
subdivision (ii) of this subparagraph, for example, if an individual 
were to transfer property constructed by him to a corporation in 
exchange for all of the capital stock of such corporation, and such 
transfer qualifies under section 351, then the corporation would be 
deemed to have constructed the property, since the basis of the property 
in the hands of the corporation would, under section 362 be determined 
by reference to the basis of the property in the hands of the 
individual. Under subdivision (iii) of this subparagraph, for example, 
if a corporation were to exchange property constructed by it for 
property of like kind constructed by another person, and such exchange 
qualifies under section 1031(a), then the corporation would be deemed to 
have constructed the property received by it in the exchange, since the 
basis of the property received by it in the exchange would, under 
section 1031(d), be determined by reference to the basis of the property 
constructed by the corporation.
    (6) In determining whether a corporation is a collapsible 
corporation by reason of the purchase of property, it is immaterial 
whether the property is purchased from the shareholders of the 
corporation or from persons other than such shareholders. The property, 
however, must be property which, in the hands of the corporation, is 
property of a kind described in section 341(b)(3). The determination 
whether property is of a kind described in section 341(b)(3) shall be 
made without regard to the fact that the corporation is formed or 
availed of with a view to the action described in section 341(b)(1).

[[Page 164]]

    (7) Section 341 is applicable whether the shareholder is an 
individual, a trust, an estate, a partnership, a company, or a 
corporation.
    (b) Section 341 assets. For the purposes of this section, the term 
``section 341 assets'' means the following listed property if held for 
less than 3 years:
    (1) Stock in trade of the corporation, or other property of a kind 
which would properly be included in the inventory of the corporation if 
on hand at the close of the taxable year.
    (2) Property held primarily for sale to customers in the ordinary 
course of a trade or business.
    (3) Property used in a trade or business as defined in section 
1231(b) and held for less than 3 years, except property that is or has 
been used in connection with the manufacture, construction, production 
or sale of property described in subparagraphs (1) and (2) of this 
paragraph.
    (4) Unrealized receivables or fees pertaining to property listed in 
this paragraph. The term unrealized receivables or fees means any rights 
(contractual or otherwise) to payment for property listed in 
subparagraphs (1), (2), and (3) of this paragraph which has been 
delivered or is to be delivered and rights to payments for services 
rendered or to be rendered, to the extent such rights have not been 
included in the income of the corporation under the method of accounting 
used by it. In determining whether the assets referred to in this 
paragraph have been held for 3 years, the time such assets were held by 
a transferor shall be taken into consideration (section 1223). However, 
no such period shall begin before the date the manufacture, 
construction, production, or purchase of such assets is completed.



Sec. 1.341-3  Presumptions.

    (a) Unless shown to the contrary a corporation shall be considered 
to be a collapsible corporation if at the time of the transactions 
described in Sec. 1.341-1 the fair market value of the section 341 
assets held by it constitutes 50 percent or more of the fair market 
value of its total assets and the fair market value of the section 341 
assets is 120 percent or more of the adjusted basis of such assets. In 
determining the fair market value of the total assets, cash, obligations 
which are capital assets in the hands of the corporation, governmental 
obligations, and stock in any other corporation shall not be taken into 
consideration. The failure of a corporation to meet the requirements of 
this paragraph, shall not give rise to the presumption that the 
corporation was not a collapsible corporation.
    (b) The following example will illustrate the application of this 
section:

    Example. A corporation, filing its income tax returns on the accrual 
basis, on July 31, 1955, owned assets with the following fair market 
values: Cash, $175,000; note receivable held for investment, $130,000; 
stocks of other corporations, $545,000; rents receivable, $15,000; and a 
building constructed by the corporation in 1953 and held thereafter as 
rental property, $750,000. The adjusted basis of the building on that 
date was $600,000. The only debt outstanding was a $500,000 mortgage on 
the building. On July 31, 1955, the corporation liquidated and 
distributed all of its assets to its shareholders. In computing whether 
the fair market value of the section 341 assets (only the building) is 
50 percent or more of the fair market value of the total assets, the 
cash, note receivable, and stocks of other corporations are not taken 
into account in determining the value of the total assets, with the 
result that the fair market value of the total assets was $765,000 
($750,000 (building) plus $15,000 rents receivable). Therefore, the 
value of the building is 98 percent of the total assets ($750,000/
$765,000). The value of the building is also 125 percent of the adjusted 
basis of the building ($750,000/$600,000). In view of the above facts, 
there arises a presumption that the corporation is a collapsible 
corporation.



Sec. 1.341-4  Limitations on application of section.

    (a) General. This section shall apply only to the extent that the 
recognized gain of a shareholder upon his stock in a collapsible 
corporation would be considered, but for the provisions of this section, 
as gain from the sale or exchange of a capital asset held for more than 
1 year (6 months for taxable years before 1977; 9 months for taxable 
years beginning in 1977). Thus, if a taxpayer sells at a gain stock of a 
collapsible corporation which he had held for six months or less, this 
section would not, in any event, apply to such gain. Also, if it is 
determined, under provisions of law other than section 341, that a sale

[[Page 165]]

or exchange at a gain of stock of a collapsible corporation which has 
been held for more than 1 year (6 months for taxable years before 1977; 
9 months for taxable years beginning in 1977) results in ordinary income 
rather than long-term capital gain, then this section (including the 
limitations contained herein) has no application whatsoever to such 
gain.
    (b) Stock ownership rules. (1) This section shall apply in the case 
of gain realized by a shareholder upon his stock in a collapsible 
corporation only if the shareholder, at any time after the actual 
commencement of the manufacture, construction, or production of the 
property, or at the time of the purchase of the property described in 
section 341(b)(3) or at any time thereafter, (i) owned, or was 
considered as owning, more than 5 percent in value of the outstanding 
stock of the corporation, or (ii) owned stock which was considered as 
owned at such time by another shareholder who then owned, or was 
considered as owning, more than 5 percent in value of the outstanding 
stock of the corporation.
    (2) The ownership of stock shall be determined in accordance with 
the rules prescribed by section 544(a)(1), (2), (3), (5), and (6), 
except that, in addition to the persons prescribed by section 544(a)(2), 
the family of an individual shall include the spouses of that 
individual's brothers and sisters, whether such brothers and sisters are 
by the whole or the half blood, and the spouses of that individual's 
lineal descendants.
    (3) For the purpose of this limitation, treasury stock shall not be 
considered as outstanding stock.
    (4) It is possible, under this limitation, that a shareholder in a 
collapsible corporation may have gain upon his stock in that corporation 
treated differently from the gain of another shareholder in the same 
collapsible corporation.
    (c) Seventy-percent rule. (1) This section shall apply to the gain 
recognized during a taxable year upon the stock in a collapsible 
corporation only if more than 70 percent of such gain is attributable to 
the property referred to in section 341(b)(1). If more than 70 percent 
of such gain is so attributable, then all of such gain is subject to 
this section, and, if 70 percent or less of such gain is so 
attributable, then none of such gain is subject to this section.
    (2) For the purpose of this limitation, the gain attributable to the 
property referred to in section 341(b)(1) is the excess of the 
recognized gain of the shareholder during the taxable year upon his 
stock in the collapsible corporation over the recognized gain which the 
shareholder would have if the property had not been manufactured, 
constructed, produced, or purchased. In the case of gain on a 
distribution in partial liquidation or a distribution described in 
section 301(c)(3)(A), the gain attributable to the property shall not be 
less than an amount which bears the same ratio to the gain on such 
distribution as the gain which would be attributable to the property if 
there had been a complete liquidation at the time of such distribution 
bears to the total gain which would have resulted from such complete 
liquidation.
    (3) Gain may be attributable to the property referred to in section 
341(b)(1) even though such gain is represented by an appreciation in the 
value of property other than that manufactured, constructed, produced, 
or purchased. Where, for example, a corporation owns a tract of land and 
the development of one-half of the tract increases the value of the 
other half, the gain attributable to the developed half of the tract 
includes the increase in the value of the other half.
    (4) The following example will illustrate the application of the 70 
percent rule:

    Example: On January 2, 1954, A formed the Z Corporation and 
contributed $1,000,000 cash in exchange for all of the stock thereof. 
The Z Corporation invested $400,000 in one project for the purpose of 
building and selling residential houses. As of December 31, 1954, the 
residential houses in this project were all sold, resulting in a profit 
of $100,000 (after taxes). Simultaneously with the development of the 
first project and in connection with a second and separate project the Z 
Corporation invested $600,000 in land for the purpose of subdividing 
such land into lots suitable for sale as home sites and distributing 
such lots in liquidation before the realization by the corporation of a 
substantial part of the taxable income to be realized from this second 
project. As of December 31, 1954,

[[Page 166]]

Corporation Z had derived $60,000 in profits (after taxes) from the sale 
of some of the lots. On January 2, 1955, the Z Corporation made a 
distribution in complete liquidation to shareholder A who received:
    (i) $560,000 in cash and notes, and
    (ii) Lots having a fair market value of $940,000.


The gain recognized to shareholder A upon the liquidation is $500,000 
($1,500,000 minus $1,000,000). The gain which would have been recognized 
to A if the second project had not been undertaken is $100,000 
($1,100,000 minus $1,000,000). Therefore, the gain attributable to the 
second project which is property referred to in section 341(b)(1), is 
$400,000 ($500,000 minus $100,000). Since this gain ($400,000) is more 
than 70 percent of the entire gain ($500,000) recognized to A on the 
liquidation, the entire gain so recognized is gain subject to section 
341(a).

    (d) Three-year rule. This section shall not apply to that portion of 
the gain of a shareholder that is realized more than three years after 
the actual completion of the manufacture, construction, production, or 
purchase of the property referred to in section 341(b)(1) to which such 
portion is attributable. However, if the actual completion of the 
manufacture, construction, production, or purchase of all of such 
property occurred more than 3 years before the date on which the gain is 
realized, this section shall not apply to any part of the gain realized.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6738, 29 FR 
7671, June 16, 1964; T.D. 7728, 45 FR 72650, Nov. 3, 1980]



Sec. 1.341-5  Application of section.

    (a) Whether or not a corporation is a collapsible corporation shall 
be determined under the regulations of Sec. Sec. 1.341-2 and 1.341-3 on 
the basis of all the facts and circumstances in each particular case. 
The following paragraphs of this section set forth those facts which 
will ordinarily be considered sufficient to establish that a corporation 
is or is not a collapsible corporation. The facts set forth in the 
following paragraphs of this section are not exclusive of other facts 
which may be controlling in any particular case. For example, if the 
facts in paragraph (b) of this section, but not the facts in paragraph 
(c) of this section, are present, the corporation may nevertheless not 
be a collapsible corporation if there are other facts which clearly 
establish that the regulations of Sec. Sec. 1.341-2 and 1.341-3 are not 
satisfied. Similarly, if the facts in paragraph (c) of this section are 
present, the corporation may nevertheless be a collapsible corporation 
if there are other facts which clearly establish that the corporation 
was formed or availed of in the manner described in Sec. Sec. 1.341-2 
and 1.341-3 or if the facts in paragraph (c) of this section are not 
significant by reason of other facts, such as the fact that the 
corporation is subject to the control of persons other than those who 
were in control immediately prior to the manufacture, construction, 
production, or purchase of the property. See Sec. 1.341-4 for 
provisions which make section 341 inapplicable to certain shareholders 
of collapsible corporations.
    (b) The following facts will ordinarily be considered sufficient 
(except as otherwise provided in paragraph (a) of this section and 
paragraph (c) of this section) to establish that a corporation is a 
collapsible corporation:
    (1) A shareholder of the corporation sells or exchanges his stock, 
or receives a liquidating distribution, or a distribution described in 
section 301(c)(3)(A),
    (2) Upon such sale, exchange, or distribution, such shareholder 
realizes gain attributable to the property described in subparagraphs 
(4) and (5) of this paragraph, and
    (3) At the time of the manufacture, construction, production, or 
purchase of the property described in subparagraphs (4) and (5) of this 
paragraph, such activity was substantial in relation to the other 
activities of the corporation which manufactured, constructed, produced, 
or purchased such property.

The property referred to in subparagraphs (2) and (3) of this paragraph 
is that property or the aggregate of those properties which meet the 
following two requirements:
    (4) The property is manufactured, constructed, or produced by the 
corporation or by another corporation stock of which is held by the 
corporation, or is property purchased by the corporation or by such 
other corporation which (in the hands of the corporation holding such 
property) is

[[Page 167]]

property described in section 341(b)(3), and
    (5) At the time of the sale, exchange, or distribution described in 
subparagraph (1) of this paragraph, the corporation which manufactured, 
constructed, produced, or purchased such property has not realized a 
substantial part of the taxable income to be derived from such property.

In the case of property which is a unit of an integrated project 
involving several properties similar in kind, the rules of this 
subparagraph shall be applied to the aggregate of the properties 
constituting the single project rather than separately to such unit. 
Under the rules of this subparagraph, a corporation shall be considered 
a collapsible corporation by reason of holding stock in other 
corporations which manufactured, constructed, produced, or purchased the 
property only if the activity of the corporation in holding stock in 
such other corporations is substantial in relation to the other 
activities of the corporation.
    (c) The absence of any of the facts set forth in paragraph (b) of 
this section or the presence of the following facts will ordinarily be 
considered sufficient (except as otherwise provided in paragraph (a) of 
this section) to establish that a corporation is not a collapsible 
corporation:
    (1) In the case of a corporation subject to paragraph (b) of this 
section only by reason of the manufacture, construction, production, or 
purchase (either by the corporation or by another corporation the stock 
of which is held by the corporation) of property which is property 
described in section 341(b)(3)(A) and (B), the amount (both in quantity 
and value) of such property is not in excess of the amount which is 
normal--
    (i) For the purpose of the business activities of the corporation 
which manufactured, constructed, produced, or purchased the property if 
such corporation has a substantial prior business history involving the 
use of such property and continues in business, or
    (ii) For the purpose of an orderly liquidation of the business if 
the corporation which manufactured, constructed, produced, or purchased 
such property has a substantial prior business history involving the use 
of such property and is in the process of liquidation.
    (2) In the case of a corporation subject to paragraph (b) of this 
section with respect to the manufacture, construction, or production 
(either by the corporation or by another corporation the stock of which 
is held by the corporation) of property, the amount of the unrealized 
taxable income from such property is not substantial in relation to the 
amount of the taxable income realized (after the completion of a 
material part of such manufacture, construction, or production, and 
prior to the sale, exchange, or distribution referred to in paragraph 
(b)(1) of this section) from such property and from other property 
manufactured, constructed, or produced by the corporation.
    (d) The following examples will illustrate the application of this 
section:

    Example 1. (i) On January 2, 1954, A formed the W Corporation and 
contributed $50,000 cash in exchange for all of the stock thereof. The W 
Corporation borrowed $900,000 from a bank and used $800,000 of such sum 
in the construction of an apartment house on land which it purchased for 
$50,000. The apartment house was completed on December 31, 1954. On 
December 31, 1954, the corporation, having determined that the fair 
market value of the apartment house, separate and apart from the land, 
was $900,000, made a distribution (permitted under the applicable State 
law) to A of $100,000. At this time, the fair market value of the land 
was $50,000. As of December 31, 1954, the corporation has not realized 
any earnings and profits. In 1955, the corporation began the operation 
of the apartment house and received rentals therefrom. The corporation 
has since continued to own and operate the building. The corporation 
reported on the basis of the calendar year and cash receipts and 
disbursements.
    (ii) Since A received a distribution and realized a gain 
attributable to the building constructed by the corporation, since, at 
the time of such distribution, the corporation has not realized a 
substantial part of the taxable income to be derived from such building, 
and since the construction of the building was a substantial activity of 
the corporation, the W Corporation is considered a collapsible 
corporation under paragraph (b) of Sec. 1.341-5. The provisions of 
section 341(d) do not prohibit the application of section 341(a). 
Therefore, the distribution, if and to the extent that it may be 
considered long-term capital gain rather than ordinary income without 
regard to section 341, will be considered ordinary income under section 
341(a).

[[Page 168]]

    (iii) In the event of the existence of additional facts and 
circumstances in the above case, the corporation, notwithstanding the 
above facts, might not be considered a collapsible corporation. See 
Sec. 1.342-2 and paragraph (a) of Sec. 1.341-5.
    Example 2. (i) On January 2, 1954, B formed X Corporation and became 
its sole shareholder. In August 1954, the corporation completed 
construction of an office building. It immediately sold this building at 
a gain of $50,000, included this entire gain in its return for 1954, and 
distributed this entire gain (less taxes) to B. In June 1955, the 
corporation completed construction of a second office building. In 
August 1955, B sold the entire stock of X Corporation at a gain of 
$12,000, which gain is attributable to the second building.
    (ii) X Corporation is a collapsible corporation under section 341(b) 
for the following reasons: The gain realized through the sale of the 
stock of X Corporation was attributable to the second office building; 
the construction of that building was a substantial activity of X 
Corporation during the time of construction and, at the time of sale, 
the corporation had not realized a substantial part of the taxable 
income to be derived from such building. Since the provisions of section 
341(d) do not prohibit the application of section 341 (a) to B, the gain 
of $12,000 to B is, accordingly, considered ordinary income.
    Example 3. The facts are the same as in Example (2), except that the 
following facts are shown: B was the president of the X Corporation and 
active in the conduct of its business. The second building was 
constructed as the first step in a project of the X Corporation for the 
development for rental purposes of a large suburban center involving the 
construction of several buildings by the corporation. The sale of the 
stock by B was caused by his retiring from all business activity as a 
result of illness arising after the second building was constructed. 
Under these additional facts, the corporation is not considered a 
collapsible corporation. See Sec. 1.341-2 and paragraph (a) of Sec. 
1.341-5.
    Example 4. (i) On January 2, 1948, C formed the Y Corporation and 
became the sole shareholder thereof. The Y Corporation has been engaged 
solely in the business of producing motion pictures and licensing their 
exhibition. On January 2, 1955, C sold all of the stock of the Y 
Corporation at a gain. The Y Corporation has produced one motion picture 
each year since its organization and before January 2, 1955, it has 
realized a substantial part of the taxable income to be derived from 
each of its motion pictures except the last one made in 1954. This last 
motion picture was completed September 1, 1954. As of January 2, 1955, 
no license had been made for its exhibition. The fair market value on 
January 2, 1955, of this last motion picture exceeds the cost of its 
production by $50,000. A material part of the production of this last 
picture was completed on January 1, 1954, and between that date and 
January 2, 1955, the corporation had realized taxable income of $500,000 
from other motion pictures produced by it. The corporation has 
consistently distributed to its shareholder its taxable income when 
received (after adjustment for taxes).
    (ii) Although the corporation is within paragraph (b) of this 
section with respect to the production of property, the amount of the 
unrealized income from such property ($50,000) is not substantial in 
relation to the amount of the income realized, after the completion of a 
material part of the production of such property and prior to sale of 
the stock, from such property and other property produced by the 
corporation ($500,000). Accordingly, the Y Corporation is within 
paragraph (c)(2) of this section, and is not considered a collapsible 
corporation.
    Example 5. The facts are the same as in Example (4) except that C 
sold all of his stock to D on February 1, 1954. On January 2, 1955, D 
sold all of the Y Corporation stock at a gain, the gain being 
attributable to the picture completed September 1, 1954, and not 
released by the corporation for exhibition. In view of the change of 
control of the corporation, the provisions of paragraph (c)(2) of this 
section are not significant at the time of the sale by D, and the Y 
Corporation would be considered a collapsible corporation on January 2, 
1955. See Sec. 1.341-2 and paragraph (a) of Sec. 1.341-5.



Sec. 1.341-6  Exceptions to application of section.

    (a) In general--(1) Transactions excepted. Section 341(e) excepts 4 
types of transactions from the application of the collapsible 
corporation provisions. These exceptions, where applicable, eliminate 
the necessity of determining whether a corporation is a collapsible 
corporation within the meaning of section 341(b) or whether any of the 
limitations of section 341(d) are applicable. Under section 341(e)(1) 
and (2), there are 2 exceptions which are designed to allow the 
shareholders of a corporation either to sell or exchange their stock or 
to receive distributions in certain complete liquidations without having 
any gain considered under section 341(a)(1) or (2) as gain from the sale 
or exchange of property which is not a capital asset. Under section 
341(e)(3), a third exception is designed to permit the shareholders of a 
corporation to make use of section 333, relating to elections as to 
recognition of gain in

[[Page 169]]

certain complete liquidations occurring within one calendar month. Under 
section 341(e)(4), the fourth exception permits a corporation to make 
use of section 337, relating to nonrecognition of gain or loss on sales 
or exchanges of property by a corporation following the adoption of a 
plan of complete liquidation. Section 341(e) does not apply to 
distributions in partial liquidation or in redemption of stock (other 
than any such distribution pursuant to a plan of complete liquidation), 
or to distributions described in section 301(c)(3)(A).
    (2) Effective date. The exceptions in section 341(e)(1), (2), and 
(3) apply only with respect to taxable years of shareholders beginning 
after December 31, 1957, and only with respect to sales or exchanges of 
stock and distributions of property occurring after September 2, 1958. 
The exception in section 341(e)(4) applies only with respect to taxable 
years of corporations beginning after December 31, 1957, and only if all 
sales or exchanges of property, and all liquidating distributions, made 
by the corporation under the plan of complete liquidation occur after 
September 2, 1958.
    (3) Definition of constructive shareholder and attribution rules. 
(i) For purposes of this section, the term constructive shareholder 
means a person who does not actually own any stock but who is considered 
to own stock by reason of the application of subdivision (ii) of this 
subparagraph.
    (ii) For purposes of this section (other than paragraph (k), 
relating to definition of related person) a person shall be considered 
to own the stock he actually owns plus any stock which is attributed to 
him by reason of applying the rules prescribed in paragraph (b)(2) and 
(3) of Sec. 1.341-4. See section 341(e)(10).
    (iii) As an example of this subparagraph, if a husband does not 
actually own any stock in a corporation but his wife is the actual owner 
of 5 shares in the corporation, then the husband is a constructive 
shareholder who is considered to own 5 shares in the corporation.
    (4) General corporate test. No exception provided in section 341(e) 
applies unless a general corporate test and, where applicable, a 
specific shareholder test are satisfied. Under the general corporate 
test no taxpayer may utilize the provisions of section 341(e) unless the 
net increase in value (called ``net unrealized appreciation'') in the 
corporation's ``subsection (e) assets'' does not exceed 15 percent of 
the corporation's net worth. Subsection (e) assets are, in general, 
those assets of the corporation which, if sold at a gain by the 
corporation or by any actual or constructive shareholder who is 
considered to own more than 20 percent in value of the outstanding 
stock, would result in the realization of ordinary income. See paragraph 
(b) of this section for the definition of subsection (e) assets, and 
paragraph (h) of this section for definition of net unrealized 
appreciation. This subparagraph may be illustrated by the following 
examples:

    Example 1. X Corporation is in the business of selling whiskey. The 
net unrealized appreciation in its whiskey is $20,000 and the net worth 
of the corporation is $100,000. Since the corporation's whiskey is a 
subsection (e) asset and since the net unrealized appreciation in 
subsection (e) assets ($20,000) exceeds 15 percent of net worth 
($15,000), the general corporate test is not satisfied and section 
341(e) is inapplicable to the corporation or its shareholders.
    Example 2. Assume the same facts as in Example (1) except that X 
Corporation is not in the business of selling whiskey. Assume further 
that an actual shareholder who owns more than 20 percent in value of the 
outstanding X stock (or a person who is considered to own such actual 
shareholder's stock, such as his spouse) is in the business of selling 
whiskey. The result is the same as in Example (1).

    (5) Specific shareholder test. Even if the general corporate test is 
met, a shareholder selling or exchanging his stock or receiving a 
distribution with respect to his stock (referred to as a ``specific 
shareholder'') who is considered to own more than 5 percent in value of 
the outstanding stock of the corporation may not utilize the benefits of 
the exception in section 341(e)(1) (or the exception in section 
341(e)(2)) unless he satisfies the applicable specific shareholder test. 
In general, the specific shareholder test is satisfied if the net 
unrealized appreciation in subsection (e) assets of the corporation, 
plus the net unrealized appreciation in certain other assets of the 
corporation which would be subsection (e) assets in respect of the 
specific shareholder

[[Page 170]]

under the following circumstances, does not exceed 15 percent of the 
corporation's net worth:
    (i) If the specific shareholder is considered to own more than 5 
percent but not more than 20 percent in value of the outstanding stock, 
he must take into account the net unrealized appreciation in assets of 
the corporation which would be subsection (e) assets if he was 
considered to own more than 20 percent in value of the outstanding stock 
(see paragraph (c)(3)(i) of this section);
    (ii) In addition, if the specific shareholder is considered to own 
more than 20 percent in value of the outstanding stock, he must also 
take into account the net unrealized appreciation in assets of the 
corporation which would be subsection (e) assets under section 
341(e)(5)(A)(i) and (iii) if his ownership within the preceding 3 years 
of stock in certain ``related'' corporations were taken into account in 
the manner prescribed in paragraphs (c)(3)(ii) and (d) of this section.
    (b) Subsection (e) asset defined--(1) General. The benefits of 
section 341(e) are unavailable if the net unrealized appreciation (as 
defined in paragraph (h) of this section) in certain assets of the 
corporation (hereinafter called ``subsection (e) assets'') exceeds 15 
percent of the corporation's net worth. In determining whether property 
is a subsection (e) asset, it is immaterial whether the property is 
described in section 341(b), and there shall not be taken into account 
sections 617(d) (relating to gain from dispositions of certain mining 
property), 1245 and 1250 (relating to gain from dispositions of certain 
depreciable property), 1251 (relating to gain from disposition of farm 
property where farm losses offset nonfarm income), 1252 (relating to 
gain from disposition of farm land), and 1254 (relating to gain from 
disposition of natural resource recapture property).
    (2) Categories of subsection (e) assets. The term subsection (e) 
assets, as defined in section 341(e)(5)(A)(i), (ii), (iii), and (iv), 
means the following categories of property held by a corporation:
    (i) The first category is property (except property described in 
section 1231(b), without regard to any holding period prescribed 
therein) which in the hands of the corporation is, or in the hands of 
any actual or constructive shareholder who is considered to own more 
than 20 percent in value of the outstanding stock of the corporation 
would be, property gain from the sale or exchange of which would under 
any provision of chapter 1 of the Code (other than section 617(d), 1245, 
1250, 1251, 1252, or 1254) be considered in whole or in part as gain 
from the sale or exchange of property which is neither a capital asset 
nor property described in section 1231(b). For example, included in this 
category is property held by a corporation which in its hands is stock 
in trade, inventory, or property held by it primarily for sale to 
customers in the ordinary course of its trade or business regardless of 
whether such property is appreciated or depreciated in value. Also 
included in this category is property held by a corporation which is a 
capital asset in its hands but which, in the hands of any actual or 
constructive shareholder who is considered to own more than 20 percent 
in value of the outstanding stock, would be stock in trade, inventory, 
or property held by such actual or constructive shareholder primarily 
for sale to customers in the ordinary course of his trade or business. 
For additional rules relating to whether property is a subsection (e) 
asset under this subdivision, see subparagraphs (3), (4), and (5) of 
this paragraph.
    (ii) The second category of subsection (e) assets is property which 
in the hands of the corporation is property described in section 1231(b) 
(without regard to any holding period prescribed therein), but only if 
there is net unrealized depreciation (within the meaning of paragraph 
(h)(2) of this section) on all such property. This subdivision may be 
illustrated by the following example:

    Example. X Corporation owns only the following section 1231(b) 
property (determined without regard to holding period).

------------------------------------------------------------------------
                                                  Fair     Unreal- ized
           Oil leaseholds             Adjusted   market    appreciation
                                        basis     value   (depreciation)
------------------------------------------------------------------------
No. 1...............................   $16,000   $10,000      ($6,000)
No. 2...............................     8,000     5,000       (3,000)
No. 3...............................     5,000     5,000             0

[[Page 171]]

 
No. 4...............................     3,000     5,000         2,000
                                     -----------------------------------
 Totals.............................    32,000    25,000       (7,000)
------------------------------------------------------------------------


Since with respect to such property the unrealized depreciation in 
property on which there is unrealized depreciation ($9,000) exceeds the 
unrealized appreciation in property on which there is unrealized 
appreciation ($2,000), all such property is included in subsection (e) 
assets under clause (ii) of section 341(e)(5)(A).

    (iii) The third category of subsection (e) assets exists only if 
there is net unrealized appreciation on all property which in the hands 
of the corporation is property described in section 1231(b) (without 
regard to any holding period prescribed therein). In such case, any such 
section 1231(b) property (whether appreciated or depreciated) is a 
subsection (e) asset of the third category if, in the hands of an actual 
or constructive shareholder who is considered to own more than 20 
percent in value of the outstanding stock of the corporation, such 
property would be property gain from the sale or exchange of which would 
under any provision of chapter 1 of the Code (other than section 617(d), 
1245, 1250, 1251, 1252, or 1254) be considered in whole or in part as 
gain from the sale or exchange of property which is neither a capital 
asset nor property described in section 1231(b). Included in this 
category, for example, is property which in the hands of the corporation 
is property described in section 1231(b) (without regard to any holding 
period prescribed therein), but which in the hands of an actual or 
constructive more-than-20-percent shareholder would be property used in 
his trade or business held for not more than 1 year (6 months for 
taxable years beginning before 1977; 9 months for taxable years 
beginning in 1977), stock in trade, inventory, or property held by such 
shareholder primarily for sale to customers in the ordinary course of 
his trade or business. For additional rules relating to whether property 
is a subsection (e) asset under this subdivision, see subparagraphs (3) 
and (4) of this paragraph. This subdivision may be further illustrated 
by the following example:

    Example. Assume the same facts as stated in the example under 
subdivision (ii) of this subparagraph, except that in addition to the 
oil leaseholds the corporation also owns land which has a fair market 
value of $30,000 and an adjusted basis of $20,000 and which in the hands 
of the corporation is property described in section 1231(b) (without 
regard to any holding period prescribed therein). Assume further that A 
is a constructive shareholder of the corporation who is considered to 
own 25 percent in value of its outstanding stock and that A holds land 
primarily for sale to customers in the ordinary course of his trade or 
business, and that no actual or constructive shareholder who is 
considered to own more than 20 percent in value of the stock of 
corporation X so holds oil leases. Since with respect to the 
corporation's section 1231(b) property the unrealized appreciation in 
such property on which there is unrealized appreciation ($12,000) 
exceeds the unrealized depreciation in such property on which there is 
unrealized depreciation ($9,000), then clause (iii), and not clause 
(ii), of section 341(e)(5)(A) is applicable. Therefore, no oil lease of 
the corporation is a subsection (e) asset. However, since in the hands 
of A, a more-than-20-percent constructive shareholder, the land would be 
property gain from the sale or exchange of which would be considered as 
gain from the sale or exchange of property which is neither a capital 
asset nor property described in section 1231(b), the land is a 
subsection (e) asset. Consequently, the net unrealized appreciation on 
subsection (e) assets of the corporation is $10,000 since the net 
unrealized depreciation on the oil leases is not taken into account.

    (iv) The fourth category of subsection (e) assets is property 
(unless included under subdivision (i), (ii), or (iii) of this 
subparagraph) which consists of a copyright, a literary, musical, or 
artistic composition, a letter or memorandum, or similar property, or 
any interest in any such property, if the property was created in whole 
or in part by the personal efforts of, or, in the case of a letter, 
memorandum, or property similar to a letter or memorandum, was prepared, 
or produced in whole or in part, for, any individual actual or 
constructive shareholder who is considered to own more than 5 percent in 
value of the outstanding stock of the corporation. For items included in 
the phrase ``similar property'' see paragraph (c) of Sec. 1.1221-1. In 
general, property is created in whole or in part by the personal efforts 
of an individual if

[[Page 172]]

such individual performs literary, theatrical, musical, artistic, or 
other creative or productive work which affirmatively contributes to the 
creation of the property, or if such individual directs and guides 
others in the performance of such work. An individual, such as a 
corporate executive, who merely has administrative control of writers, 
actors, artists, or personnel and who does not substantially engage in 
the direction and guidance of such persons in the performance of their 
work, does not create property by his personal efforts. However, a 
letter or memorandum, or property similar to a letter or memorandum, 
which is prepared by personnel who are under the administrative control 
of an individual, such as a corporate executive, shall be deemed to have 
been prepared or produced for him whether or not such letter, 
memorandum, or similar property is reviewed by him. In addition, a 
letter, memorandum, or property similar to a letter or memorandum, 
addressed to an individual shall be considered as prepared or produced 
for him. In the case of a letter, memorandum, or property similar to a 
letter or memorandum, this subdivision applies only to sales and other 
dispositions occurring after July 25, 1969.
    (3) Manner of determination. For purposes of determining whether 
property is a subsection (e) asset under subparagraph (2)(i) or (iii) of 
this paragraph, the determination as to whether property of a 
corporation in the hands of the corporation is, or in the hands of an 
actual or constructive shareholder of the corporation would be, property 
gain from the sale or exchange of which would under any provision of 
chapter 1 of the Code (other than section 617(d), 1245, 1250, 1251, 
1252, or 1254) be considered in whole or in part as gain from the sale 
or exchange of property which is neither a capital asset nor property 
described in section 1231(b) shall be made as if all property of the 
corporation had been sold or exchanged to one person in one transaction. 
For example, if a corporation whose sole asset is an interest in a gas 
well has entered into a long-term contract for the future delivery of 
gas from the well, the ownership of which will pass to the buyer only 
after extraction or severance from the well, the determination as to 
whether such contract is a subsection (e) asset shall be made as if the 
contract were sold or exchanged to one person in one transaction 
together with such corporation's interest in the well. An assumed sale 
under this subparagraph does not affect the character of property which 
is held for sale to customers in the ordinary course of a person's trade 
or business or the character of a transaction which would be an 
anticipatory assignment of income. Thus, for example, if a corporation 
holds subdivided lots for sale to customers in the ordinary course of 
its trade or business, this subparagraph shall not be applied to change 
the manner in which the lots are held.
    (4) Shareholder reference test. For purposes of subparagraph (2)(i) 
and (iii) of this paragraph, in determining whether any property of the 
corporation would, in the hands of a particular actual or constructive 
shareholder, be property gain from the sale or exchange of which would 
be considered in whole or in part as gain from the sale or exchange of 
property which is neither a capital asset nor property described in 
section 1231(b), all the facts and circumstances of the direct and 
indirect activities of the shareholder must be taken into account. If 
the particular shareholder holds property primarily for sale to 
customers in the ordinary course of his trade or business and if similar 
property is held by the corporation, then in the hands of the 
shareholder such corporate property will be treated as held primarily 
for sale to customers in the ordinary course of his trade or business. 
Moreover, even if the shareholder does not presently so hold property 
which is similar to property held by the corporation, it may be 
determined under the particular facts and circumstances (taking into 
account an assumed sale of such corporate property by the shareholder, 
all his other direct and indirect activities, and, if applicable, the 
fact that he previously so held similar property) that he would hold the 
corporate property primarily for sale to customers in the

[[Page 173]]

ordinary course of his trade or business. See also paragraph (d) of this 
section, pertaining to effect of stock in related corporations.
    (5) Special rule for stock in shareholder's investment account. If--
    (i) A dealer in stock or securities is an actual shareholder 
(considered to own more than 20 percent of the outstanding stock of a 
corporation) and holds such stock which he actually owns in his 
investment account pursuant to section 1236(a), or
    (ii) A dealer in stock or securities is a constructive shareholder 
who is considered to own more than 20 percent of the outstanding stock 
of a corporation,

then stock or securities held by such corporation shall not be 
considered subsection (e) assets under subparagraph (2)(i) of this 
paragraph solely because such actual or constructive shareholder is a 
dealer in stock or securities. However, stock held by such corporation 
shall be considered as a subsection (e) asset if, in the hands of any 
more-than-20-percent actual or constructive shareholder of the 
corporation, the gain (or any portion thereof) upon a sale of such stock 
would (if it were held for more than 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977), 
constitute, by reason of the application of section 341, gain from the 
sale of property which is not a capital asset. This subparagraph may be 
illustrated by the following example:

    Example. Jones, a more-than-20-percent actual shareholder in 
corporation X holds his X stock in an investment account in the manner 
prescribed in section 1236(a). Jones is a dealer in stock and securities 
and holds land for sale to customers in the ordinary course of his trade 
or business. No other actual or constructive shareholder is a dealer in 
stock and securities or so holds land. X holds all of the stock in 
corporation Y, a collapsible corporation within the meaning of section 
341(b). Y's sole asset is land on which unrealized appreciation exceeds 
15 percent of Y's net worth. Since Jones holds his X stock in an 
investment account pursuant to section 1236(a), the Y stock cannot be 
considered a subsection (e) asset of the X Corporation merely because 
Jones is a dealer in stock and securities. Nevertheless, the Y stock is 
a subsection (e) asset of the X Corporation because if Jones were 
treated as having sold the Y stock, his gain would be treated as gain 
from the sale of property which is not a capital asset by reason of the 
application of section 341. If, however, the net unrealized appreciation 
on Y's land did not exceed 15 percent of Y's net worth the Y stock would 
not be a subsection (e) asset since section 341(e)(1) would except such 
sale from the application of section 341.

    (c) Sales or exchanges of stock--(1) General. Section 341(e)(1) 
provides that, if certain requirements are satisfied, the provisions of 
section 341(a)(1) shall in no event apply to certain sales or exchanges 
of stock by a shareholder. See subparagraph (5) of this paragraph for 
sales or exchanges of stock which do not qualify under section 
341(e)(1). Section 341(e)(1) applies to a sale or exchange of stock by a 
shareholder only if, at the time of such sale or exchange, the general 
corporate test and, if applicable, the specific shareholder test are 
satisfied.
    (2) General corporate test. The general corporate test is satisfied 
if the net unrealized appreciation in subsection (e) assets of the 
corporation does not exceed an amount equal to 15 percent of the net 
worth of the corporation. See paragraphs (h), (b), and (j) of this 
section for the definition of ``net unrealized appreciation,'' 
``subsection (e) assets,'' and ``net worth.''
    (3) Specific shareholder test. The specific shareholder test (if 
applicable) is satisfied if the following conditions are met:
    (i) If the shareholder selling or exchanging the stock is considered 
to own more than 5 percent but not more than 20 percent in value of the 
outstanding stock, the sum of the net unrealized appreciation in the 
following assets of the corporation must not exceed an amount equal to 
15 percent of the net worth of the corporation:
    (a) The subsection (e) assets of the corporation, plus
    (b) The other assets of the corporation which would be subsection 
(e) assets under section 341(e)(5)(A)(i) and (iii) if such shareholder 
were considered to own more than 20 percent in value of the outstanding 
stock.
    (ii) If the shareholder selling or exchanging the stock is 
considered to own more than 20 percent in value of the outstanding 
stock, the sum of the net unrealized appreciation in the following 
assets of the corporation must

[[Page 174]]

not exceed an amount equal to 15 percent of the net worth of the 
corporation:
    (a) The subsection (e) assets of the corporation, plus
    (b) The other assets of the corporation which would be subsection 
(e) assets under section 341(e)(5)(A)(i) and (iii) if the shareholder's 
ownership of stock in certain related corporations were taken into 
account in the manner prescribed in paragraph (d) of this section.
    (4) Example. Subparagraph (3) of this paragraph may be illustrated 
by the following example:

    Example. Assume an individual, A, and his grandfather, G, each 
actually owns 3 percent in value of the stock of corporation X, a 
corporation holding apartment houses used in its trade or business on 
which net unrealized appreciation exceeds 15 percent of X's net worth. 
A, but not G, holds apartment houses primarily for sale to customers in 
the ordinary course of trade or business. Assume that X satisfies the 
general corporate test. A and G desire to sell their stock and to take 
advantage of section 341(e)(1). Since a grandfather and grandson are 
each considered to own the other's stock under paragraph (a)(3)(ii) of 
this section, A and G are each considered to own 6 percent in value of 
corporation X's outstanding stock. Therefore, A cannot avail himself of 
section 341(e)(1) since he does not satisfy the specific shareholder 
test prescribed in subparagraph (3)(i) of this paragraph. G, however, 
who is considered to own 6 percent in value of the stock, does not hold 
apartment houses for sale to customers in the ordinary course of trade 
or business. Therefore, G satisfies the specific shareholder test and 
may benefit from section 341(e)(1).

    (5) Nonqualifying sales or exchanges. Section 341(e)(1) does not 
apply to any sale or exchange of stock to the issuing corporation. Thus, 
stock redemptions (including distributions in complete or partial 
liquidation) cannot qualify under section 341(e)(1). In addition, 
section 341(e)(1) does not apply in any case where a shareholder who is 
considered to own more than 20 percent in value of the outstanding stock 
sells or exchanges stock to any person related (within the meaning of 
paragraph (k) of this section) to such shareholder. A sale or exchange 
of stock of the corporation by a shareholder to which section 341(e)(1) 
does not apply because of this subparagraph shall have no effect on the 
application of this section to other sales or exchanges of stock of the 
corporation.
    (6) Example. For an illustration of the application of this 
paragraph, see Example (2) in paragraph (o) of this section.
    (d) Stock in related corporations--(1) General. This paragraph 
provides rules for applying the specific shareholder test prescribed in 
paragraph (c)(3)(ii) of this section for purposes of determining whether 
section 341(e)(1) (relating to sales or exchanges of stock of a 
corporation) or section 341(e)(2) (relating to distributions in complete 
liquidation of a corporation) applies to an actual shareholder who is 
considered as owning more than 20 percent in value of the corporation's 
outstanding stock. In general, if such a more-than-20-percent 
shareholder of such corporation (referred to as a ``first'' corporation) 
owns, or at any time during the preceding 3 years has owned, more than 
20 percent in value of the outstanding stock of a ``related'' 
corporation (see subparagraph (2) of this paragraph), then certain 
transactions in respect of the stock of the related corporation are 
taken into account in the manner prescribed in subparagraph (3) of this 
paragraph. By taking such transactions into account, such shareholder of 
the first corporation may be deemed to hold primarily for sale to 
customers in the ordinary course of trade or business property similar 
or related in service or use to property owned by the first corporation 
where his other activities, direct and indirect, are insufficient to 
treat him as so holding such property. See section 341(e)(1)(C) and 
(2)(C). The transactions in respect of stock in a related corporation 
are taken into account solely for the purpose of determining the extent 
to which assets (other than subsection (e) assets) of the first 
corporation are treated as subsection (e) assets under the shareholder 
reference tests of section 341(e)(5)(A)(i) and (iii). For purposes of 
this paragraph, the term ``similar or related in service or use'' shall 
have the same meaning as such term has in section 1033 (relating to 
involuntary conversions), without regard to subsection (g) thereof.

[[Page 175]]

    (2) Related corporation defined. (i) A corporation (referred to as a 
``second'' corporation) is ``related'' to another corporation (referred 
to as a ``first'' corporation) if the stock ownership test specified in 
subdivision (ii) of this subparagraph and the more-than-70-percent-asset 
comparison test specified in subdivision (iii) of this subparagraph are 
met.
    (ii) The stock ownership test specified in this subdivision is met--
    (a) In the case of a sale or exchange referred to in paragraph 
(c)(1) of this section, if the shareholder in the first corporation is 
considered to own on the date of such sale or exchange more than 20 
percent in value of the outstanding stock of the first corporation, and 
if on such date (or at any time during the 3-year period preceding such 
date) such shareholder in the first corporation is an actual or 
constructive shareholder in the second corporation who was considered to 
own more than 20 percent in value of the outstanding stock of the second 
corporation, or
    (b) In the case of a distribution pursuant to the adoption by the 
first corporation of a plan of complete liquidation referred to in 
paragraph (e) of this section, if the shareholder in the first 
corporation is considered to own on any date after the adoption of such 
plan more than 20 percent in value of the outstanding stock of the first 
corporation, and if on such date (or at any time during the 3-year 
period preceding such date) such shareholder in the first corporation 
was an actual or constructive shareholder in the second corporation who 
was considered to own more than 20 percent in value of the outstanding 
stock of the second corporation.
    (iii) The more-than-70-percent-asset comparison test specified in 
this subdivision is met if more than 70 percent in value of the assets 
of the second corporation (at any of the applicable times determined 
under subdivision (ii) of this subparagraph during which the shareholder 
of the first corporation is or was considered to own more than 20 
percent in value of the outstanding stock of the second corporation) 
are, or were, assets similar or related in service or use to assets 
comprising more than 70 percent in value of the assets of the first 
corporation (at any of the times determined under subdivision (ii) of 
this subparagraph during which the shareholder of the first corporation 
is or was considered to own more than 20 percent in value of the 
outstanding stock of the first corporation).
    (iv) This subparagraph may be illustrated by the following example:

    Example. X is a first corporation and Y is a second corporation. On 
January 15, 1960, Jones purchased 21 percent in value of the outstanding 
stock of X, which he sold on January 1, 1961. On January 15, 1955, Jones 
had purchased 21 percent in value of the outstanding stock of Y which he 
sold on December 15, 1959. Since Jones owned 21 percent of the 
outstanding X stock on January 1, 1961 (the date he sold his X stock) 
and also owned 21 percent of the outstanding Y stock at some time during 
the 3-year period preceding January 1, 1961, the stock ownership test 
specified in subdivision (ii)(a) of this subparagraph is met. Assume 
that more than 70 percent in value of the assets of Y were apartment 
houses held for rental purposes at some time between January 1, 1958, 
and December 15, 1959 (the portion of the 3-year period preceding the 
date Jones sold his X stock during which he was a more-than-20-percent 
shareholder in Y) and that more than 70 percent in value of the assets 
of X were apartment houses held for rental purposes at some time during 
the period January 15, 1960, to January 1, 1961, inclusive (the portion 
of the 3-year period preceding the date he sold his X stock during which 
he was a more-than-20-percent shareholder in X). Thus, the more-than-70-
percent-asset comparison test specified in subdivision (iii) of this 
subparagraph is met. Accordingly, corporation Y is related to 
corporation X within the meaning of this subparagraph.

    (3) Manner of taking into account. If an actual shareholder in a 
first corporation who is considered to own more than 20 percent of the 
first corporation's stock, owns or has owned stock in a related 
corporation, then--
    (i) Any sale or exchange by such shareholder, during the applicable 
period specified in subparagraph (2)(ii) of this paragraph, of stock in 
the related corporation shall be treated as a sale or exchange by him of 
his proportionate share of the assets of the related corporation, if 
immediately before such sale or exchange he was an actual shareholder of 
the related corporation who was considered to own more than 20 percent 
in value of the

[[Page 176]]

outstanding stock of the related corporation. A shareholder's 
proportionate share of the assets of a related corporation shall be that 
percent of each asset of the related corporation as the fair market 
value of the stock of the related corporation which he actually sold or 
exchanged bears, immediately before such sale or exchange, to the total 
fair market value of the outstanding stock of such related corporation; 
and
    (ii) Any sale or exchange of property by the related corporation 
during the applicable period specified in subparagraph (2)(ii) of this 
paragraph, gain or loss on which was not recognized to the related 
corporation by reason of the application of section 337(a), shall be 
treated as a sale or exchange by him of his proportionate share of the 
related corporation's property sold or exchanged, if at the time of such 
sale or exchange he was an actual or constructive shareholder of the 
related corporation who was considered to own more than 20 percent in 
value of the outstanding stock of such related corporation. A 
shareholder's proportionate share of such related corporation's property 
sold or exchanged shall be that percent of each such property sold or 
exchanged as the fair market value of the stock which he was considered 
to own in the related corporation immediately before such sale or 
exchange bears to the total fair market value of the outstanding stock 
of such related corporation at such time.
    (4) Example. This paragraph may be illustrated by the following 
example:

    Example. (i) A owns 25 percent in value of the outstanding stock of 
Z Corporation. On December 31, 1959, he sells all his stock in the 
corporation and desires to take advantage of section 341(e)(1). The only 
asset of Z Corporation is an appreciated apartment house held for rental 
purposes but which is not a subsection (e) asset. However, during the 
preceding 3-year period A sold 25 percent in value of the outstanding 
stock of each of 3 related corporations. More than 70 percent in value 
of the assets of each related corporation consisted of an apartment 
house.
    (ii) In determining whether the apartment house owned by Z 
Corporation would be a subsection (e) asset under the shareholder 
reference test of section 341(e)(5)(A)(iii), A is treated as having sold 
a one-fourth interest in each of 3 apartment houses during the preceding 
3-year period and these sales must be taken into account, together with 
all other facts and circumstances, in determining whether the apartment 
house owned by Z Corporation would be, in the hands of A, property gain 
from the sale or exchange of which would under any provision of chapter 
1 of the Code (other than section 1245 or 1250) be considered as gain 
from the sale or exchange of property which is neither a capital asset 
nor property described in section 1231(b). However, A's sales of related 
corporation stock are not taken into account in determining whether 
section 341(e)(1) or (2) would be applicable to sales or exchanges of 
stock by (or liquidating distributions to) other shareholders of Z 
Corporation.

    (e) Distributions in certain liquidations pursuant to section 337--
(1) In general. Section 341(e)(2) provides that, if certain requirements 
are met, the provisions of section 341(a)(2) shall in no event apply to 
certain distributions in complete liquidation of a corporation. Section 
341(e)(2) applies with respect to any distribution to a shareholder 
pursuant to a plan of complete liquidation if the following 3 
requirements are satisfied:
    (i) By reason of the application of section 341(e)(4) and paragraph 
(g) of this section, section 337(a) applies to sales or exchanges of 
property by the corporation within the 12-month period beginning on the 
date of the adoption of such plan. Thus, for example, section 341(e)(2) 
is not applicable in any case where depreciable, amortizable, or 
depletable property is distributed after the date of adoption of the 
plan or if the corporation does not sell substantially all of the 
properties held by it on such date within such 12-month period, since 
such a distribution, or the failure to make such a sale, makes section 
337(a) inapplicable under section 341(e)(4).
    (ii) At all times within such 12-month period the general corporate 
test of paragraph (c)(2) of this section is satisfied.
    (iii) In respect of the shareholder who receives the distribution--
    (a) At all times within such 12-month period while such shareholder 
is considered to own more than 5 percent but not more than 20 percent in 
value of the outstanding stock of the corporation, the shareholder must 
satisfy the specific shareholder test of paragraph (c)(3)(i) of this 
section, and

[[Page 177]]

    (b) At all times within such 12-month period while such shareholder 
is considered to own more than 20 percent in value of the outstanding 
stock of the corporation, the shareholder must satisfy the specific 
shareholder test of paragraph (c)(3)(ii) of this section.
    (2) Illustration. For an illustration of this paragraph, see Example 
(4) in paragraph (o) of this section.
    (f) Recognition of gain in certain liquidations under section 333. 
Section 341(e)(3) provides that, for purposes of section 333 (relating 
to elections as to recognition of gain in certain complete liquidations 
occurring within one calendar month), a corporation is considered not to 
be a collapsible corporation if, at all times after the adoption of the 
plan of complete liquidation, the net unrealized appreciation in 
subsection (e) assets of the corporation does not exceed an amount equal 
to 15 percent of the net worth of the corporation. For purposes of the 
preceding sentence, the determination of subsection (e) assets shall be 
made in accordance with paragraph (b) of this section except that 
subparagraph (2)(i) and (iii) of such paragraph (b) shall apply in 
respect of any actual or constructive shareholder who is considered to 
own more than 5 percent in value of the outstanding stock (in lieu of 
any actual or constructive shareholder who is considered to own more 
than 20 percent in value of such stock). Thus, no shareholder of the 
corporation can qualify under paragraph (3) of section 341(e) for use of 
section 333 if, because of any actual or constructive shareholder who is 
considered to own more than 5 percent in value of the stock, this 
modified general corporate test is not satisfied. On the other hand, 
once this modified general corporate test is satisfied, all the 
shareholders can use section 333 (assuming that the requirements of that 
section are satisfied) since there is no specific shareholder test. For 
an illustration of this paragraph, see Example (3) in paragraph (o) of 
this section.
    (g) Gain or loss on sales or exchanges in connection with certain 
liquidations, pursuant to section 337--(1) General. Section 341(e)(4) 
provides that solely for purposes of section 337, a corporation is 
considered not to be a collapsible corporation if (i) at all times 
within the 12-month period beginning on the date of the adoption of a 
plan of complete liquidation, the net unrealized appreciation in 
subsection (e) assets of the corporation does not exceed an amount equal 
to 15 percent of the net worth of the corporation; (ii) within the 12-
month period beginning on the date of the adoption of such plan, the 
corporation sells substantially all of the properties held by it on such 
date; and (iii) following the adoption of such plan, no distribution is 
made of any property which in the hands of the corporation or in the 
hands of the distributee is property in respect of which a deduction for 
exhaustion, wear and tear, obsolescence, amortization, or depletion is 
allowable. Thus, if at the time of the adoption of the plan of 
liquidation the corporation is a collapsible corporation within the 
meaning of section 341(b) and if the preceding requirements are 
satisfied, then except as provided in subparagraph (2) of this paragraph 
section 337(a) will apply to such corporation but the corporation will 
continue to be a collapsible corporation within the meaning of section 
341(b) (including for purposes of section 341(e)(2)) with the result 
that each shareholder must still satisfy all the tests in paragraph (e) 
of this section before he can utilize the benefits of section 341(e)(2).
    (2) Exception to section 337 treatment. Section 341(e)(4) shall not 
apply with respect to any sale or exchange of property by the 
corporation to any actual or constructive shareholder who is considered 
to own more than 20 percent in value of the outstanding stock of the 
corporation or to any person related (within the meaning of paragraph 
(k) of this section) to such actual or constructive shareholder if such 
property in the hands of the corporation, or in the hands of such 
shareholder or such related person, is property in respect of which a 
deduction for exhaustion, wear and tear, obsolescence, amortization, or 
depletion is allowable. Thus, gain or loss will be recognized on such 
sales or exchanges.
    (3) Cross references. For effective date of section 341(e)(4) and 
this paragraph, see paragraph (a)(2) of this section. For an 
illustration of this paragraph, see Example (4) in paragraph (o) of this 
section.

[[Page 178]]

    (h) Net unrealized appreciation and depreciation defined--(1) Net 
unrealized appreciation. For purposes of this section, the term net 
unrealized appreciation means, with respect to the assets of a 
corporation, the amount by which--
    (i) The unrealized appreciation in such assets on which there is 
unrealized appreciation, exceeds
    (ii) The unrealized depreciation in such assets on which there is 
unrealized depreciation.
    (2) Net unrealized depreciation. For purposes of paragraph 
(b)(2)(ii) of this section, there is net unrealized depreciation on all 
property of a corporation which in its hands is property described in 
section 1231(b) (without regard to any holding period prescribed 
therein) if--
    (i) The unrealized depreciation in such property on which there is 
unrealized depreciation, exceeds
    (ii) The unrealized appreciation in such property on which there is 
unrealized appreciation.
    (3) Unrealized appreciation or depreciation. For purposes of this 
paragraph--
    (i) The term unrealized appreciation means (except as provided in 
subparagraph (4) of this paragraph), with respect to any asset, the 
amount by which (a) the fair market value of such asset, exceeds (b) the 
adjusted basis for determining gain from the sale or other disposition 
of such asset; and
    (ii) The term unrealized depreciation means, with respect to any 
asset, the amount by which (a) the adjusted basis for determining gain 
from the sale or other disposition of such asset, exceeds (b) the fair 
market value of such asset.
    (4) Special rule. For purposes of determining whether the net 
unrealized appreciation in subsection (e) assets of a corporation 
exceeds an amount equal to 15 percent of the corporation's net worth 
under the tests of section 341(e)(1), (2), (3), and (4), in the case of 
any asset on the sale or exchange of which only a portion of the gain 
would under any provision of chapter 1 of the Code (other than section 
617(d), 1245, 1250, 1251, 1252, or 1254) be considered as gain from the 
sale or exchange of property which is neither a capital asset nor 
property described in section 1231(b), there shall be taken into account 
only an amount equal to the unrealized appreciation in such asset which 
is equal to such portion of the gain. This subparagraph shall have no 
effect on whether paragraph (b)(2)(ii) or (iii) of this section applies 
for purposes of identifying the subsection (e) assets of the 
corporation.
    (i) [Reserved]
    (j) Net worth defined. For purposes of this section, the net worth 
of a corporation, as of any day, is the amount by which--
    (1) The fair market value of all its assets at the close of such 
day, plus the amount of any distribution (taken into account at fair 
market value on the date of such distribution) in complete liquidation 
made by it on or before such day, exceeds
    (2) All its liabilities at the close of such day.

In computing the fair market value of all the assets of a corporation at 
the close of such day, there shall be excluded any amount attributable 
to money or property received by it during the one-year period ending on 
such day for stock, or as a contribution to capital or as paid-in 
surplus, if it appears that there was not a bona fide business purpose 
for the transaction in respect of which such money or property was 
received.
    (k) Related person defined--(1) General. For purposes of paragraphs 
(c)(5) and (g)(2) of this section, the following persons are considered 
to be related to a shareholder:
    (i) If the shareholder is an individual--
    (a) His spouse, ancestors, and lineal descendants, and
    (b) Any corporation which is controlled by him.
    (ii) If the shareholder is a corporation--
    (a) A corporation which controls, or is controlled by, such 
shareholder, and
    (b) If more than 50 percent in value of the outstanding stock of 
such shareholder is owned by any person, any corporation more than 50 
percent in value of the outstanding stock of which is owned by the same 
person.
    (2) Control. For purposes of this paragraph, control means the 
ownership of stock possessing at least 50 percent of the total combined 
voting power of all classes of stock entitled to vote or at

[[Page 179]]

least 50 percent of the total value of shares of all classes of stock of 
the corporation.
    (3) Constructive ownership rules. In determining the ownership of 
stock for purposes of this paragraph, the constructive ownership rules 
of section 267(c) shall apply, except that the family of an individual 
shall include only his spouse, ancestors, and lineal descendants.
    (l) [Reserved]
    (m) Corporations and shareholders not meeting requirements. In 
determining whether the provisions of section 341 (a) through (d) apply 
with respect to any corporation, the fact that such corporation, or such 
corporation with respect to any of its shareholders, does not meet the 
requirements of section 341(e)(1), (2), (3), or (4) shall not be taken 
into account, and such determination shall be made as if section 341(e) 
had not been enacted.
    (n) Determinations without regard to sections 617(d), 1245, 1250, 
1251, 1252, and 1254. For purposes of this section, the determination of 
whether gain from the sale or exchange of property would under any 
provision of chapter 1 of the Code be considered as gain from the sale 
or exchange of property which is neither a capital asset nor property 
described in section 1231(b) shall be made without regard to the 
application of sections 617(d)(1) (relating to gain from dispositions of 
certain mining property), 1245(a) and 1250(a) (relating to gain from 
dispositions of certain depreciable property), 1251(c) (relating to gain 
from the disposition of farm property where farm losses offset nonfarm 
income), 1252(a) (relating to gain from disposition of farm land), and 
1254(a) (relating to gain from disposition of interest in natural 
resource recapture property).
    (o) Illustrations. The operation of section 341(e) may be 
illustrated by the following examples:

    Example 1. (i) The outstanding stock of X Corporation is actually 
owned, on the basis of value, 75 percent by A, 15 percent by B, and 10 
percent by C. None of the stock actually owned by one is attributed to 
another under the constructive ownership rules of paragraph (a)(3) of 
this section. The corporation owns no property which, in its hands, is 
property gain from the sale or exchange of which would be considered 
(without regard to section 617(d), 1245 or 1250, 1251, or 1252) as gain 
from the sale or exchange of property which is neither a capital asset 
nor property described in section 1231(b). The corporation owns no 
property described in section 1231(b) except an apartment house on which 
the unrealized appreciation is $20,000 and which in the hands of A would 
be property held primarily for sale to customers in the ordinary course 
of trade or business. The corporation owns no property of the type 
described in clause (iv) of section 341(e)(5)(A). The net worth of the 
corporation is $100,000.
    (ii) Although the apartment house in the hands of the corporation is 
section 1231(b) property, in the hands of A, a more-than-20-percent 
shareholder, the apartment house would be ordinary-income type property. 
Therefore, the apartment house is a subsection (e) asset under clause 
(iii) of section 341(e)(5)(A). Accordingly, since the net unrealized 
appreciation in subsection (e) assets ($20,000) exceeds 15 percent of 
net worth ($15,000), the general corporate test is not satisfied and 
section 341(e) is unavailable to the corporation or its shareholders.
    Example 2. (i) Assume the same facts as in Example (1), except that 
in the hands of B, but not in the hands of A or C, the apartment house 
would be property held primarily for sale to customers in the ordinary 
course of trade or business.
    (ii) Since B does not own more than 20 percent in value of the 
outstanding stock, the fact that the apartment house owned by the 
corporation would, in his hands, be property held primarily for sale to 
customers in the ordinary course of trade or business does not make the 
apartment house owned by the corporation a subsection (e) asset. 
Therefore, since the net unrealized appreciation in subsection (e) 
assets (zero) does not exceed 15 percent of net worth, the general 
corporate test is satisfied. C may sell his stock to anyone (other than 
X Corporation) and will qualify under section 341(e)(1). However, a sale 
by A of his stock to persons related to A within the meaning of 
paragraph (k) of this section will not so qualify.
    (iii) B, however, since he owns more than 5 percent but not more 
than 20 percent in value of the outstanding stock, must take into 
account not only the net unrealized appreciation in subsection (e) 
assets but also the net unrealized appreciation in any other assets of 
the corporation which would be subsection (e) assets under section 
341(e)(5)(A) if he owned more than 20 percent in value of the 
outstanding stock. Therefore, since the apartment house owned by the 
corporation would be, in B's hands, property held primarily for sale to 
customers in the ordinary course of trade or business, and since the net 
unrealized appreciation in such property ($20,000) exceeds 15 percent of 
net

[[Page 180]]

worth ($15,000), B does not satisfy the specific shareholder test and 
therefore cannot avail himself of section 341(e)(1).
    Example 3. (i) Assume the same facts as in Example (1), except that 
in the hands of B, but not in the hands of A or C, the apartment house 
of the corporation would be property held primarily for sale to 
customers in the ordinary course of trade or business. Assume further 
that the shareholders of X Corporation wish to avail themselves of 
section 333.
    (ii) For purposes of section 341(e)(3), section 341(e)(5)(A)(iii) 
applies in respect of any shareholder who owns more than 5 percent 
(instead of more than 20 percent) in value of the outstanding stock. 
Since in the hands of B, a more-than-5-percent shareholder, the 
apartment house would be held primarily for sale to customers in the 
ordinary course of trade or business, the corporation's apartment house 
is a subsection (e) asset. Therefore, since the net unrealized 
appreciation in subsection (e) assets ($20,000) exceeds 15 percent of 
net worth ($15,000), no shareholder of the corporation may qualify under 
section 341(e)(3) for use of section 333. However, if B were not a more-
than-5-percent shareholder of the corporation, or if, in his hands, the 
apartment house would not be held primarily for sale to customers in the 
ordinary course of trade or business, then all shareholders of the 
corporation could qualify under section 341(e)(3) for use of section 333 
since the apartment house would not be a subsection (e) asset.
    Example 4. (i) Assume the same facts as in Example (1), except that 
in the hands of no shareholder of the corporation would the apartment 
house be deemed property held primarily for sale to customers in the 
ordinary course of trade or business (such determination, however, 
having been made without regard to A's ownership of stock of related 
corporations). Assume further that (a) X Corporation adopts a plan of 
complete liquidation, (b) within the 12-month period beginning on the 
date of such adoption X Corporation sells substantially all the property 
held by it on such date and distributes all its assets in complete 
liquidation, (c) following the adoption of such plan, no distribution is 
made of any property which in the hands of the corporation or in the 
hands of the distributee is property in respect of which a deduction for 
exhaustion, wear and tear, obsolescence, amortization, or depletion is 
allowable, and (d) following the adoption of such plan no property is 
sold or exchanged to A, to a constructive owner of A's stock, or to a 
person ``related'' (within the meaning of paragraph (k) of this section) 
to A or such constructive owner.
    (ii) Since, under the above-stated facts, the requirements of 
section 341(e)(4) are satisfied, section 337(a) will apply to sales or 
exchanges of property by the corporation within the 12-month period 
beginning on the date of the adoption of the plan of liquidation.
    (iii) Any distribution in complete liquidation to B and C, who own 
15 and 10 percent, respectively, in value of the outstanding stock, will 
qualify under section 341(e)(2) because (a) by reason of the application 
of section 341(e)(4), section 337(a) applies to sales or exchanges of 
property by the corporation, and (b) at all times within the 12-month 
period beginning on the date of the adoption of the plan of complete 
liquidation the general corporate test is satisfied and B and C each 
satisfy the specific shareholder test of paragraph (e)(1)(iii)(a) of 
this section.
    (iv) Any distribution in complete liquidation to A, who owns 75 
percent in value of the outstanding stock, will qualify under section 
341(e)(2) if, at all times within the 12-month period beginning on the 
date of the adoption of the plan of complete liquidation, and after 
taking into account A's ownership of stock in related corporations in 
the manner prescribed in paragraph (d) of this section, A satisfies the 
specific shareholder test of paragraph (e)(1)(iii)(b) of this section.

[T.D. 6806, 30 FR 2845, Mar. 5, 1965, as amended by T.D. 7369, 40 FR 
29840, July 16, 1975; T.D. 7418, 41 FR 18811, May 7, 1976; T.D. 7728, 45 
FR 72650, Nov. 3, 1980; T.D. 8586, 60 FR 2500, Jan. 10, 1995]



Sec. 1.341-7  Certain sales of stock of consenting corporations.

    (a) In general. (1) Under section 341(f)(1), if a corporation 
consents (in the manner provided in paragraph (b) of this section) to 
the application of section 341(f)(2) with respect to dispositions by it 
of its subsection (f) assets (as defined in paragraph (g) of this 
section), then section 341(a)(1) does not apply to any sales of stock of 
such consenting corporation (other than sale to such corporation) made 
by any of its shareholders within the 6-month period beginning on the 
date on which such consent is filed.
    (2) For purposes of section 341(f)(1) and (5)--
    (i) The term sale means a sale of exchange of stock at a gain, but 
only if such gain would be recognized as long-term capital gain were 
section 341 not a part of the Code. Thus, a sale or exchange of stock is 
not a ``sale'' within the meaning of section 341(f)(1) and (5) if there 
is no gain on the transaction, or if the sale or exchange gives rise to 
ordinary income under a provision of the Code other than section 341, or 
if

[[Page 181]]

gain on the transaction is not recognized under any provisions of 
subtitle A of the Code.
    (ii) A sale of stock in a corporation does not include any 
disposition of such stock by a shareholder, if, by reason of section 
341(d)(1), section 341(a) could not have applied to that disposition. 
(Under section 341(d)(1), section 341(a) does not apply except to more-
than-5-percent shareholders.) Except as otherwise provided in paragraph 
(a)(2)(i) of this section, the term ``sale'' included a disposition of 
stock in a corporation by a more-than-5-percent shareholders described 
in section 341(d)(1), even though section 341(a) did not apply to the 
disposition because the corporation was not collapsible or by reason of 
the application of section 341(d)(2), (3), or (e).
    (3) A corporation which consents to the application of section 
341(f)(2) does not thereby become noncollapsible, and the fact that a 
corporation consents to the application of section 341(f)(2) does not 
affect the determination as to whether it is a collapsible corporation.
    (4) For limitation on the application of section 341(f)(1) see 
section 341(f)(5) and (6) and paragraphs (h) and (j) of this section.
    (b) Statement of consent. (1) The consent of a corporation referred 
to in paragraph (a)(1) or (j)(1) of this section shall be given by means 
of a statement, signed by any officer who is duly authorized to act on 
behalf of the consenting corporation stating that the corporation 
consents to have the provisions of section 341(f)(2) apply to any 
disposition by it of its subsection (f) assets. The statement shall be 
filed with the district director having jurisdiction over the income tax 
return of the consenting corporation for the taxable year during which 
the statement is filed.
    (2)(i) The statement shall contain the name, address, and employer 
identification number of any corporation 5 percent or more in value of 
the outstanding stock of which is owned directly by the consenting 
corporation, and of any other corporation connected to the consenting 
corporation through a chain of stock ownership described in paragraph 
(j)(4) of this section. The statement shall also indicate where such 5-
percent-or-more corporation (or such ``connected'' corporation) has 
consented within the 6-month period ending on the date on which the 
statement filed to the application of section 341 (f)(2) with respect to 
any dispositions of its subsection (f) assets (see paragraph (j) of this 
section), and, if so, the district director with whom such consent was 
filed and the date on which such consent was filed.
    (ii) If, during the 6-month period beginning on the date on which 
the statement is filed, the consenting corporation becomes the owner of 
5 percent or more in value of the outstanding stock of another 
corporation or becomes connected to another corporation through a chain 
of stock ownership described in paragraph (j)(4) of this section, then 
the consenting corporation shall, within 5 days after such occurrence, 
notify the district director with whom it filed the statement of the 
name, address and employer identification number of such corporation.
    (3) A consent under section 341(f)(1) may be filed at any time and 
there is no limit as to the number of such consents that may be filed. 
If a consent is filed by a corporation under section 341(f)(1) and if a 
shareholder sells stock (i) in such corporation, or (ii) in another 
corporation a sale of whose stock is treated under section 341(f)(6) as 
a sale of stock in such corporation, at any time during the applicable 
6-month period, then the consent cannot thereafter be revoked or 
withdrawn by the corporation. However, a consent may be revoked or 
withdrawn at any time prior to a sale during the applicable 6-month 
period. If no sale is made during such period, the consent will have no 
effect on the corporation. See paragraph (g) of this section.
    (c) Consenting corporation. (1) A consenting corporation at the time 
that is filed a consent under section 341(f)(10) shall notify its 
shareholders that such consent is being filed. In addition, the 
consenting corporation shall, at the request of any shareholder, 
promptly supply the shareholder with a copy of the consent.
    (2) A consenting corporation shall maintain records adequate to 
permit identification of its subsection (F) assets.

[[Page 182]]

    (d) Shareholders of consenting corporation. (1) A shareholder who 
sells stock in a consenting corporation within the 6-month period 
beginning on the date on which the consent is filed shall--
    (i) Notify the corporation, within 5 days after such sale, of the 
date on which such sale is made, and
    (ii) Attach a copy of the corporation's consent to the shareholder's 
income tax return for the taxable year in which the sale is made.
    (2) If the sale of stock in a consenting corporation is treated 
under section 341(f)(6) as the sale of stock in any other corporation, 
the consenting corporation shall notify such other corporation, within 5 
days after receiving notification of a sale of its stock, of the date on 
which such sale was made.
    (e) Recognition of gain under section 341(f)(2). (1) Under section 
341(f)(2), if a subsection (f) asset (as defined in paragraph (g) of 
this section) is disposed of any time by a consenting corporation, then, 
except as provided in section 341(f)(3) and paragraph (f) of this 
section, the amount by which--
    (i) The amount realized (in the case of a sale, exchange, or 
involuntary conversion), or
    (ii) The fair market value of such asset (in the case of any other 
disposition), exceeds the adjusted base of such asset is treated as gain 
from the sale of exchange of such asset. Such gain is recognized 
notwithstanding any contrary non-recognition provisions of subtitle A of 
the Code, but only to the extent such gain is not recognized under any 
other provisions of subtitle A of the Code (for example, section 1245 
(a)(1) or 1250(a)). Gain recognized under section 341(f)(2) with respect 
to a disposition of a subsection (f) asset has the same character (i.e., 
ordinary income or capital gain) that such gain would have if it arose 
from a sale of such asset.
    (2) The nonrecognition provisions of subtitle A of the Code which 
section 341(f)(2) override include, but are not limited to, sections 
311(a), 332(c), 336, 337, 351, 361, 371(a), 374(a), 721, 1031, 1033, 
1071, and 1081.
    (3) In the case of a foreign corporation which files a statement of 
consent pursuant to paragraph (b) of this section, such statement, in 
addition to the information required in paragraph (b) of this section, 
shall also contain a declaration that the corporation consents that any 
gain upon the disposition of a subsection (f) asset which would 
otherwise be recognized under section 341(f)(2) will, for purposes of 
section 882(a)(2), be considered as gross income which is effectively 
connected with the conduct of a trade or business which is conducted 
through a permanent establishment within the United States.
    (4) The provisions of subparagraphs (1) and (2) of this paragraph 
may be illustrated by the following examples:

    Example 1. Corporation X, a consenting corporation, distributes a 
subsection (f) asset to its shareholders in complete or partial 
liquidation of the corporation. The asset, at the line of the 
distribution, is held by the corporation primarily for sale to customers 
in the ordinary course of business and has an adjusted basis of $1,000 
and a fair market value of $2,000. Under section 341(f)(2), the excess 
of the fair market value of the asset over its adjusted basis, or $1,000 
is treated as ordinary income. Assuming the gain is not recognized by 
corporation X under another provision of the Code, corporation X 
recognizes the $1,000 gain as ordinary income under section 341(f)(2) 
even though, in the absence of section 341(f)(2), section 336 would 
preclude the recognition of such gain.
    Example 2. Corporation Y, a consenting corporation, distributes a 
subsection (f) asset to its shareholders as a dividend. The asset at the 
time of the distribution is properly described in section 1231 and has 
an adjusted basis of $6,000 and a fair market value of $8,000. Assuming 
that no other section of the Code would require recognition of gain, 
under section 341(f)(2) the excess of the fair market value of the asset 
over its adjusted basis, or $2,000, is recognized by corporation Y as 
gain from the sale or exchange of property described in section 1231 
even though, in the absence of section 341(f)(2), section 311(a) would 
preclude the recognition of such gain.
    Example 3. Assume the same facts as in Example (2) except that the 
subsection (f) asset is section 1245 property having a ``recomputed 
basis'' (as defined in section 1245(a)(2)) or $7,200. Since the 
recomputed basis of the asset is lower than its fair market value, the 
excess of the recomputed basis over the adjusted basis, or $1,200, is 
recognized as ordinary income under section 1245(a)(1). The remaining 
amount, or $800, is recognized under section 341(f)(2) as gain from the 
sale or exchange or property described in section 1231.

    (5) The provisions of section 341(f)(2) apply whether or not (i) on 
the date on which a consent is filed or at any time

[[Page 183]]

thereafter, the consenting corporation was in fact a collapsible 
corporation within the meaning of section 341(b), or (ii) on the date of 
any sale of stock of the consenting corporation, the purchaser of such 
stock was aware that a consent had been filed under section 341(f)(1) 
within the 6-month period ending on the date of such sale.
    (6) Section 341(f)(2) does not apply to losses. Thus, section 
341(f)(2) does not apply if a loss is realized upon a sale, exahnger or 
involuntary conversion of a subsection (f) asset nor does the section 
appy to a disposition other than by way of sale, exchange, or 
involuntary conversion if at the time of the disposition the fair market 
value of such property is not greater than its adjusted basis.
    (7) For purposes of this paragraph, the term ``disposition'' 
includes an abandonment or retirement, a gift, a sale in a sale-and-
leasback transaction, and a transfer upon the foreclosure of a security 
interest. Such term, however, does not include a mere transfer of title 
to a creditor upon creation of a security interest or to a debtor upon 
termination of a security interest. Thus, for example, a disposition 
occurs upon a sale of property prusuant to a conditional sales contract 
even though the seller retains legal title to the propoerty for purposes 
of security, but a disposition does not occur when the seller ultimately 
gives up his security interest following payment by the purchaser.
    (8) The amount of gain required to be recognized by section 
341(f)(2) shall be determined separately for each subsection (f) asset 
disposed of by the corporation. For purposes of applying section 
341(f)(2), the facts and circumstances of each disposition shall be 
considered in determining whether the transactions involves more than 
one subsection (f) asset or involves both subsection (f) and 
nonsubsection (f) assets. In appropriate cases, several subsection (f) 
assets may be treated as a single asset as long as it is reasonably 
clear, from the best estimates obtainable on the basis of all the facts 
and circumstances, that the amount of gain required to be recognized by 
section 341(f)(2) is not less than the total gain under section 
341(f)(2) whish would be computed separately for each subsection (f) 
asset.
    (9) In the case of a sale, exchange, or involuntary conversion of a 
subsection (f) asset and a nonsubsection (f) asset in one transaction, 
the total amount realized upon the disposition shall be allocated 
between the subsection (f) asset any arm's length agreement between the 
buyer and the seller will establish the allocation. In the absence of 
such an agreement, the allocation shall be made by taking into account 
the appropriate facts and circumstances. Some of the facts and 
circumstances which shall be taken into account to the extent 
appropriate included, but are not limited to, a comparision between the 
subsection (f) asset and all property disposed of in such transaction of 
(i) the original costs and reproduction costs of construction, erection, 
or production, (ii) the remaining economic useful life, (ii) state of 
obsolencence, and (iv) anticipated expenditures to maintain, renovate, 
or modernize.
    (10) See Sec. 1.1502-13 for the treatment of gain recognized upon a 
distribution other than in complete liquidation made by one member of a 
group which files a consolidated return to another such members.
    (f) Exception for certain tax-free transactions. (1) Under section 
341(f)(3), no gain is taken into account under section 341(f)(2) by a 
transferor corporation on the transfer of a subsection (f) asset to 
another corporation (other than a corporation exempt from tax imposed by 
chapter 1 of the Code) if--
    (i) The basis of such asset in the hands of the transferee 
corporation is determined by reference to its basis in the hands of the 
transferor by reason of the application of section 332 (relating to 
distributions in liquidation of an 80-percent-or-more controlled 
subsidairy corporation), section 351 (relating to transfers to a 
corporation controlled by the transferor), section 361 (relating to 
exchanges pursuant to certain reorganizations), section 371(a) (relating 
to exchanges pursuant to certain receivership and bankruptcy 
proceedings), or section 374 (a) (relating to exchanges pursuant to 
certain railroad reorganizations), and

[[Page 184]]

    (ii) The transferee corporation agrees (as provided in subparagraph 
(3) of this paragraph) to have the provisiions of section 341(f)(2) 
apply to any disposition by it of such asset.
    (2) The provisions of subparagraph (1) of this paragraph may be 
illustrated by the following examples:

    Example 1. Corporation M. in exchange for its voting stock worth 
$20,000 and $1,000 in cash, acquires the entire property of corporation 
N (an unencumbered apartment building) in a transaction which is 
described in section 368(a)(2)(B) and which, therefore, qualifies as a 
reorganization under section 368(a)(1)(C). The apartment building, which 
in the hands of corporation N. a consenting corporation, is a subsection 
(f) asset, has an adjusted basis of $15,000 and a fair market value of 
$21,000. The basis of the apartment house in the hands of corporation M 
is determined by reference to its basis in the hands of corporation N by 
reason of the application of section 361. Thus, under section 341(f)(3), 
if corporation M agrees to have the provisions of section 341(f)(2) 
apply to any disposition by it of the apartment house, then corporation 
N will recognize no gain under section 341(f)(2) but will recognize 
$1,000 gain under section 361(b) (assuming the cash it receives is not 
distributed in pursuance of the plan of reorganization). However, if 
corporation M does not so agree, the gain recognized by corporation N 
will be $6,000, that is, the gain of $1,000 recognized under section 
361(b) plus $5,000 gain recognized under section 341(f)(2). In either 
case, if section 1245, 1250, or 1251 applies, some or all of the gain 
may be recognized under sections in lieu of sections 341(f)(2) and 
361(b).
    Example 2. Corporation Y, a consenting corporation, is a wholly 
owned subsidiary of corporation X. In the complete liquidation of Y it 
distributes to X a subsection (f) asset which is section 1245 property. 
The asset at the time of the distribution has an adjusted basis of 
$10,000, a recomputed basis of $14,000, and a fair market value of 
$10,000. The basis of the asset in the hands of X is determined by 
reference to its basis in the hands of corporation Y by reason of the 
application of section 332. Thus, under section 341(f)(3), if 
corporation X agrees to have the provisions of section 341(f)(2) apply 
to any disposition by it of the subsection (f) asset, then Y will 
recognize no gain under section 341(f)(2) and will recognize no gain 
under section 1245(a)(1) by reason of the application of section 
1245(b)(3). Under section 334(b)(1), the basis of the subsection (f) 
asset to corporation X will be the same as it would be in the hands of 
Y, or $10,000. However, if corporation X does not so agree, then under 
section 341(f)(2) $6,000 (the excess of the fair market value of the 
asset over its adjusted basis) will be treated as gain from the sale or 
exchange of the asset. Moreover, under section 1245(a)(1) $4,000 (the 
excess of the recomputed basis over the adjusted basis) of the $6,000 
will be recognized as ordinary income. The basis of the asset to 
corporation X is $16,000, i.e., the same as it would be in the hands of 
Y ($10,000) increased in the amount of gain recognized by Y on the 
distribution ($6,000).

    (3) The agreement of a transferee corporation referred to in 
subparagraph (1) of this paragraph shall be filed, on or before the date 
on which the subsection (f) assets are transferred, with the district 
director having jurisdiction over its income tax return for the taxable 
year during which the transfer is to be made. The agreement shall be 
signed by any officer who is duly authorized to act on behalf of the 
transferee corporation (if the transaxtion is one to which section 
371(a) or 374(a) applies, the fiduciary for the transferee corporation, 
in appropriate cases, may sign the agreement) and shall apply to all the 
subsection (f) assets to be transferred pursuant to the applicable 
transaction described in section 341(f)(3). The agreement shall identify 
the transaction by which the subsection (f) assets will be acquired, 
including the names, addresses, and employer identification numbers of 
the transferor and transferee corporations, and shall contain a schedule 
of the subsection (f) assets to be acquired. The agreement shall also 
state that the transferee corporation (i) agrees to have the provisions 
of section 341(f)(2) apply to any disposition by it of the subsection 
(f) assets acquired, and (ii) agrees to maintain records adequate to 
permit identification of such subsection (f) assets.
    (4) The transferor corporation shall attach a copy of the agreement 
to its income tax return for the taxable year in which the subsection 
(f) assets are transferred.
    (g) Subsection (f) asset defined. (1) Under section 341(f)(4), a 
subsection (f) asset is any property which, as of the date of any sale 
of stock to which paragraph (a) or (j)(3) of this section applies, is 
not a capital asset and is property owned by, or subject to a binding 
contract or an option to acquire held by, the consenting corporation. 
Land or any interest in real property (other than a security interest) 
is treated as

[[Page 185]]

property which is not a capital asset. Also, unrealized receivables or 
fees (as defined in section 341(b)(4)) are treated as property which are 
not capital assets.
    (2) If, with respect to any property described in subparagraph (1) 
of this paragraph, manufacture, construction, or production has been 
commenced by either the consenting corporation or another person before 
any date of sale of stock described in subparagraph (1) of this 
paragraph, a consenting corporation's subsection (f) assets include any 
property resulting from such manufacture, construction, or production. 
Thus, for example, if, on the date of any sale of stock within the 6-
month period, manufacture, construction, or production has been 
commended on a tract of land to be used for residential housing or on a 
television series, the term ``subsection (f) asset'' includes the 
residential homes of the television tapes resulting from such 
manufacture, construction, or production by the consenting corporation 
(or by a transferee corporation which has agreed to the application of 
section 341(f)(2)). If land or any interest in real property (other than 
a security interest) is owned or held under an option by the consenting 
corporation on the date of any sale of stock described in subparagraph 
(1) of this paragraph, the term ``subsection (f) asset'' includes any 
improvements resulting from construction with respect to such property 
(by the consenting corporation or by a transferee corporation which has 
agreed to the application of section 341(f)(2)) if such construction is 
commenced within 2 years after the date of any such sale. The property 
or improvements resulting from any manufacture, construction, or 
production is a question to be determined on the basis of the particular 
facts and circumstances of each individual case. Thus, for example, a 
building which is a part of an integrated project is a subsection (f) 
asset if construction of the project commenced before the date of sale 
or within 2 years thereafter even if construction of the building 
commenced more than 2 years thereafter. Similarly a television tape 
which is part of a series is a subsection (i) asset if production of the 
series was commenced on the date of sale even if production of the tape 
commenced after the sale.
    (3) The provisions of subparagraphs (1) and (2) of this paragraph 
may be illustrated by the following examples:

    Example 1. Corporation X files a consent to the application of 
section 341(f)(2) on January 1, 1985. Shareholder A owns 100 percent of 
the outstanding stock of the consenting corporation on January 1, 1965, 
and sells 5 percent of the stock on January 2, 1965, 10 percent on 
February 10, 1963, and 1 percent on May 1, 1965. No other sales of X 
stock were made during the 6-month period beginning on January 1, 1965. 
On such date X owns an apartment building and on March 1 X purchases an 
office building. X's subsection (f) assets include the apartment 
building owned on January 1 and the office building purchased on March 
1.
    Example 2. Assume the same facts as in Example (1) except that on 
January 1, 1965, X also owns a tract of raw land. On April 1, 1965, 
construction of a residential housing project is commenced on the tract 
of land. Corporation X's subsection (i) assets will include the tract of 
land plus the resulting improvements to the land. This result would not 
be changed if construction of the residential housing project were not 
commenced until July 1, 1966, since the construction would have been 
commenced within 2 years after May 1, 1965.
    Example 3. Corporation X files a consent to the application of 
section 341(f)(2) on January 1, 1965. Shareholder B owns 100 percent of 
the outstanding stock of the consenting corporation on January 1, 1965, 
and sells 10 percent of the stock on June 1, 1965. On April 1, 1965, Y 
acquires an option to purchase a motion picture when completed. On May 
1, 1965, production is started on the motion picture. On February 1, 
1967, production is completed, and Y exercises its option. Y holds the 
option and the motion picture for use in its trade or business. Y's 
subsection (f) assets initially include the option and ultimately 
include the motion picture. However the exercise of the option is not a 
disposition of the option within the meaning of section 341(f)(2).

    (h) Five-year limitation as to shareholder. Under section 341(f)(5), 
section 341(f)(1) does not apply to the sale of stock of a consenting 
corporation if, during the 5-year period ending on the date of such 
sale, such shareholder (or any person related to such shareholder within 
the meaning of section 341(e)(8)(A)) made a sale (as defined in 
paragraph (a)(2) of this section) of any

[[Page 186]]

stock of another consenting corporation within any 6-month period 
beginning on a date on which a consent was filed under section 341(f)(1) 
by such other corporation. Section 341(f)(5) does not prevent a 
shareholder of a consenting corporation from receiving the benefit of 
section 341(f)(1) on the sale of additional shares of the stock of the 
same consenting corporation.
    (i) [Reserved]
    (j) Special rule for stock ownership in other corporations--(1) 
Section 341(f)(6) provides a special rule applicable to a consenting 
corporation which owns 5 percent or more in value of the outstanding 
stock of another corporation. In such a case, a consent filed by the 
consenting corporation shall not be valid with respect to a sale of its 
stock during the applicable 6-month period unless each corporation, 5 
percent or more in value of the outstanding stock of which is owned by 
the consenting corporation on the date of such sale, file (within the 6-
month period ending on the date of such sale) a valid consent under 
section 341(f)(1) with respect to sales of its own stock.
    (2) The provisions of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example: Corporation X files a consent under section 341(f)(1) on 
November 1, 1965. On January 1, 1966, the date on which a shareholder of 
corporation X sells stock of X. X owns 80 percent in value of the 
outstanding stock of corporation Y. In order for the consent filed by 
corporation X to be valid with respect to the sale of its stock on 
January 1, 1966, corporation Y must have filed, during the 6-month 
period ending on January 1, 1966, a valid consent under section 
341(f)(1) with respect to sales of its stock.

    (3) For purposes of applying section 341(f)(4) (relating to the 
definition of a subsection (f) asset) to a corporation 5 percent or more 
in value of the outstanding stock of which is owned by the consenting 
corporation, a sale of stock of the consenting corporation to which 
section 341(f)(1) applies shall be treated as a sale of stock of such 
other corporation. Thus, in the example in subparagraph (2) of this 
paragraph, the subsection (f) assets of corporation Y would include 
property described in section 341(f)(4) owned by or held under an option 
by corporation Y on January 1, 1966.
    (4) In the case of a chain of corporations connected by the 5-
percent ownership requirement described in subparagraph (1) of this 
paragraph, rules similar to the rules described in subparagraphs (2) and 
(3) of this paragraph shall apply. Thus, in the example in subparagraph 
(2) of this paragraph, if corporation Y owned 5 percent or more of the 
stock of corporation Z on January 1, 1966, then Z must have filed a 
valid consent during the 6-month period ending January 1, 1966, in order 
for the consent filed by X to be valid with respect to the sale of its 
stock on January 1, 1966. In such case any of stock of either X or Y is 
treated as a sale of stock of Z for purposes of applying section 
341(f)(4) to Z.
    (5) If a corporation is a member of an affiliated group (as defined 
in section 1504(a)) that files a consolidated return, a corporation will 
be considered to have filed a consent if a consent is filed on its 
behalf by the common parent under Sec. 1.1502-77(a).
    (k) Effective date. Paragraphs (b), (c), (e)(3), and (f)(3) of this 
section apply only with respect to statements and notifications filed 
more than 30 days after July 6, 1977. Paragraph (d) applies only with 
respect to sales of stock made more than 30 days after July 6, 1977. All 
other provisions of this section appy with respect to transactions after 
August 22, 1964.

[T.D. 7655, 44 FR 68460, Nov. 29, 1979; 45 FR 17982, Mar. 20, 1980; 45 
FR 20464, Mar. 28, 1980; T.D. 8597, 60 FR 36679, July 18, 1995]

                               definition



Sec. 1.346-1  Partial liquidation.

    (a) General. This section defines a partial liquidation. If amounts 
are distributed in partial liquidation such amounts are treated under 
section 331(a)(2) as received in part or full payment in exchange for 
the stock. A distribution is treated as in partial liquidation of a 
corporation if:
    (1) The distribution is one of a series of distributions in 
redemption of all of the stock of the corporation pursuant to a plan of 
complete liquidation, or
    (2) The distribution:
    (i) Is not essentially equivalent to a dividend,

[[Page 187]]

    (ii) Is in redemption of a part of the stock of the corporation 
pursuant to a plan, and
    (iii) Occurs within the taxable year in which the plan is adopted or 
within the succeeding taxable year.

An example of a distribution which will qualify as a partial liquidation 
under subparagraph (2) of this paragraph and section 346(a) is a 
distribution resulting from a genuine contraction of the corporate 
business such as the distribution of unused insurance proceeds recovered 
as a result of a fire which destroyed part of the business causing a 
cessation of a part of its activities. On the other hand, the 
distribution of funds attributable to a reserve for an expansion program 
which has been abandoned does not qualify as a partial liquidation 
within the meaning of section 346(a). A distribution to which section 
355 applies (or so much of section 356 as relates to section 355) is not 
a distribution in partial liquidation within the meaning of section 
346(a).
    (b) Special requirements on termination of business. A distribution 
which occurs within the taxable year in which the plan is adopted or 
within the succeeding taxable year and which meets the requirements of 
subsection (b) of section 346 falls within paragraph (a)(2) of this 
section and within section 346(a)(2). The requirements which a 
distribution must meet to fall within subsection (b) of section 346 are:
    (1) Such distribution is attributable to the corporation's ceasing 
to conduct, or consists of assets of, a trade or business which has been 
actively conducted throughout the five-year period immediately before 
the distribution, which trade or business was not acquired by the 
corporation within such period in a transaction in which gain or loss 
was recognized in whole or in part, and
    (2) Immediately after such distribution by the corporation it is 
actively engaged in the conduct of a trade or business, which trade or 
business was actively conducted throughout the five-year period ending 
on the date of such distribution and was not acquired by the corporation 
within such period in a transaction in which gain or loss was recognized 
in whole or in part.

A distribution shall be treated as having been made in partial 
liquidation pursuant to section 346(b) if it consists of the proceeds of 
the sale of the assets of a trade or business which has been actively 
conducted for the five-year period and has been terminated, or if it is 
a distribution in kind of the assets of such a business, or if it is a 
distribution in kind of some of the assets of such a business and of the 
proceeds of the sale of the remainder of the assets of such a business. 
In general, a distribution which will qualify under section 346(b) may 
consist of, but is not limited to:
    (i) Assets (other than inventory or property described in 
subdivision (ii) of this subparagraph) used in the trade or business 
throughout the five-year period immediately before the distribution (for 
this purpose an asset shall be considered used in the trade or business 
during the period of time the asset which it replaced was so used), or
    (ii) Proceeds from the sale of assets described in subdivision (i) 
of this subparagraph, and, in addition,
    (iii) The inventory of such trade or business or property held 
primarily for sale to customers in the ordinary course of business, if:
    (a) The items constituting such inventory or such property were 
substantially similar to the items constituting such inventory or 
property during the five-year period immediately before the 
distribution, and
    (b) The quantity of such items on the date of distribution was not 
substantially in excess of the quantity of similar items regularly on 
hand in the conduct of such business during such five-year period, or
    (iv) Proceeds from the sale of inventory or property described in 
subdivision (iii) of this subparagraph, if such inventory or property is 
sold in bulk in the course of termination of such trade or business and 
if with respect to such inventory the conditions of subdivision (iii)(a) 
and (b) of this subparagraph would have been met had such inventory or 
property been distributed on the date of such sale.
    (c) Active conduct of a trade or business. For the purpose of 
section 346(b)(1), a corporation shall be deemed to have actively 
conducted a trade or

[[Page 188]]

business immediately before the distribution, if:
    (1) In the case of a business the assets of which have been 
distributed in kind, the business was operated by such corporation until 
the date of distribution, or
    (2) In the case of a business the proceeds of the sale of the assets 
of which are distributed, such business was actively conducted until the 
date of sale and the proceeds of such sale were distributed as soon 
thereafter as reasonably possible.

The term active conduct of a trade or business shall have the same 
meaning in this section as in paragraph (c) of Sec. 1.355-1.



Sec. 1.346-2  Treatment of certain redemptions.

    If a distribution in a redemption of stock qualifies as a 
distribution in part or full payment in exchange for the stock under 
both section 302(a) and this section, then only this section shall be 
applicable. None of the limitations of section 302 shall be applicable 
to such redemption.



Sec. 1.346-3  Effect of certain sales.

    The determination of whether assets sold in connection with a 
partial liquidation are sold by the distributing corporation or by the 
shareholder is a question of fact to be determined under the facts and 
circumstances of each case.

               Corporate Organizations and Reorganizations

                         corporate organizations



Sec. 1.351-1  Transfer to corporation controlled by transferor.

    (a)(1) Section 351(a) provides, in general, for the nonrecognition 
of gain or loss upon the transfer by one or more persons of property to 
a corporation solely in exchange for stock or securities in such 
corporation, if immediately after the exchange, such person or persons 
are in control of the corporation to which the property was transferred. 
As used in section 351, the phrase ``one or more persons'' includes 
individuals, trusts, estates, partnerships, associations, companies, or 
corporations (see section 7701(a)(1)). To be in control of the 
transferee corporation, such person or persons must own immediately 
after the transfer stock possessing at least 80 percent of the total 
combined voting power of all classes of stock entitled to vote and at 
least 80 percent of the total number of shares of all other classes of 
stock of such corporation (see section 368(c)). In determining control 
under this section, the fact that any corporate transferor distributes 
part or all of the stock which it receives in the exchange to its 
shareholders shall not be taken into account. The phrase ``immediately 
after the exchange'' does not necessarily require simultaneous exchanges 
by two or more persons, but comprehends a situation where the rights of 
the parties have been previously defined and the execution of the 
agreement proceeds with an expedition consistent with orderly procedure. 
For purposes of this section--
    (i) Stock or securities issued for services rendered or to be 
rendered to or for the benefit of the issuing corporation will not be 
treated as having been issued in return for property, and
    (ii) Stock or securities issued for property which is of relatively 
small value in comparison to the value of the stock and securities 
already owned (or to be received for services) by the person who 
transferred such property, shall not be treated as having been issued in 
return for property if the primary purpose of the transfer is to qualify 
under this section the exchanges of property by other persons 
transferring property.

For the purpose of section 351, stock rights or stock warrants are not 
included in the term ``stock or securities.''
    (2) The application of section 351(a) is illustrated by the 
following examples:

    Example 1. C owns a patent right worth $25,000 and D owns a 
manufacturing plant worth $75,000. C and D organize the R Corporation 
with an authorized capital stock of $100,000. C transfers his patent 
right to the R Corporation for $25,000 of its stock and D transfers his 
plant to the new corporation for $75,000 of its stock. No gain or loss 
to C or D is recognized.
    Example 2. B owns certain real estate which cost him $50,000 in 
1930, but which has a fair market value of $200,000 in 1955. He 
transfers

[[Page 189]]

the property to the N Corporation in 1955 for 78 percent of each class 
of stock of the corporation having a fair market value of $200,000, the 
remaining 22 percent of the stock of the corporation having been issued 
by the corporation in 1940 to other persons for cash. B realized a 
taxable gain of $150,000 on this transaction.
    Example 3. E, an individual, owns property with a basis of $10,000 
but which has a fair market value of $18,000. E also had rendered 
services valued at $2,000 to Corporation F. Corporation F has 
outstanding 100 shares of common stock all of which are held by G. 
Corporation F issues 400 shares of its common stock (having a fair 
market value of $20,000) to E in exchange for his property worth $18,000 
and in compensation for the services he has rendered worth $2,000. Since 
immediately after the transaction, E owns 80 percent of the outstanding 
stock of Corporation F, no gain is recognized upon the exchange of the 
property for the stock. However, E realized $2,000 of ordinary income as 
compensation for services rendered to Corporation F.

    (3) Underwritings of stock--(i) In general. For the purpose of 
section 351, if a person acquires stock of a corporation from an 
underwriter in exchange for cash in a qualified underwriting 
transaction, the person who acquires stock from the underwriter is 
treated as transferring cash directly to the corporation in exchange for 
stock of the corporation and the underwriter is disregarded. A qualified 
underwriting transaction is a transaction in which a corporation issues 
stock for cash in an underwriting in which either the underwriter is an 
agent of the corporation or the underwriter's ownership of the stock is 
transitory.
    (ii) Effective date. This paragraph (a)(3) is effective for 
qualified underwriting transactions occurring on or after May 1, 1996.

    (b)(1) Where property is transferred to a corporation by two or more 
persons in exchange for stock or securities, as described in paragraph 
(a) of this section, it is not required that the stock and securities 
received by each be substantially in proportion to his interest in the 
property immediately prior to the transfer. However, where the stock and 
securities received are received in disproportion to such interest, the 
entire transaction will be given tax effect in accordance with its true 
nature, and in appropriate cases the transaction may be treated as if 
the stock and securities had first been received in proportion and then 
some of such stock and securities had been used to make gifts (section 
2501 and following), to pay compensation (section 61(a)(1)), or to 
satisfy obligations of the transferor of any kind.
    (2) The application of paragraph (b)(1) of this section may be 
illustrated as follows:

    Example 1. Individuals A and B, father and son, organize a 
corporation with 100 shares of common stock to which A transfers 
property worth $8,000 in exchange for 20 shares of stock, and B 
transfers property worth $2,000 in exchange for 80 shares of stock. No 
gain or loss will be recognized under section 351. However, if it is 
determined that A in fact made a gift to B, such gift will be subject to 
tax under section 2501 and following. Similarly, if B had rendered 
services to A (such services having no relation to the assets 
transferred or to the business of the corporation) and the disproportion 
in the amount of stock received constituted the payment of compensation 
by A to B, B will be taxable upon the fair market value of the 60 shares 
of stock received as compensation for services rendered, and A will 
realize gain or loss upon the difference between the basis to him of the 
60 shares and their fair market value at the time of the exchange.
    Example 2. Individuals C and D each transferred, to a newly 
organized corporation, property having a fair market value of $4,500 in 
exchange for the issuance by the corporation of 45 shares of its capital 
stock to each transferor. At the same time, the corporation issued to E, 
an individual, 10 shares of its capital stock in payment for 
organizational and promotional services rendered by E for the benefit of 
the corporation. E transferred no property to the corporation. C and D 
were under no obligation to pay for E's services. No gain or loss is 
recognized to C or D. E received compensation taxable as ordinary income 
to the extent of the fair market value of the 10 shares of stock 
received by him.

    (c)(1) The general rule of section 351 does not apply, and 
consequently gain or loss will be recognized, where property is 
transferred to an investment company after June 30, 1967. A transfer of 
property after June 30, 1967, will be considered to be a transfer to an 
investment company if--
    (i) The transfer results, directly or indirectly, in diversification 
of the transferors' interests, and
    (ii) The transferee is (a) a regulated investment company, (b) a 
real estate

[[Page 190]]

investment trust, or (c) a corporation more than 80 percent of the value 
of whose assets (excluding cash and nonconvertible debt obligations from 
consideration) are held for investment and are readily marketable stocks 
or securities, or interests in regulated investment companies or real 
estate investment trusts.
    (2) The determination of whether a corporation is an investment 
company shall ordinarily be made by reference to the circumstances in 
existence immediately after the transfer in question. However, where 
circumstances change thereafter pursuant to a plan in existence at the 
time of the transfer, this determination shall be made by reference to 
the later circumstances.
    (3) Stocks and securities will be considered readily marketable if 
(and only if) they are part of a class of stock or securities which is 
traded on a securities exchange or traded or quoted regularly in the 
over-the-counter market. For purposes of subparagraph (1)(ii)(c) of this 
paragraph, the term ``readily marketable stocks or securities'' includes 
convertible debentures, convertible preferred stock, warrants, and other 
stock rights if the stock for which they may be converted or exchanged 
is readily marketable. Stocks and securities will be considered to be 
held for investment unless they are (i) held primarily for sale to 
customers in the ordinary course of business, or (ii) used in the trade 
or business of banking, insurance, brokerage, or a similar trade or 
business.
    (4) In making the determination required under subparagraph 
(1)(ii)(c) of this paragraph, stock and securities in subsidiary 
corporations shall be disregarded and the parent corporation shall be 
deemed to own its ratable share of its subsidiaries' assets. A 
corporation shall be considered a subsidiary if the parent owns 50 
percent or more of (i) the combined voting power of all classes of stock 
entitled to vote, or (ii) the total value of shares of all classes of 
stock outstanding.
    (5) A transfer ordinarily results in the diversification of the 
transferors' interests if two or more persons transfer nonidentical 
assets to a corporation in the exchange. For this purpose, if any 
transaction involves one or more transfers of nonidentical assets which, 
taken in the aggregate, constitute an insignificant portion of the total 
value of assets transfered, such transfers shall be disregarded in 
determining whether diversification has occurred. If there is only one 
transferor (or two or more transferors of identical assets) to a newly 
organized corporation, the transfer will generally be treated as not 
resulting in diversification. If a transfer is part of a plan to achieve 
diversification without recognition of gain, such as a plan which 
contemplates a subsequent transfer, however delayed, of the corporate 
assets (or of the stock or securities received in the earlier exchange) 
to an investment company in a transaction purporting to qualify for 
nonrecognition treatment, the original transfer will be treated as 
resulting in diversification.
    (6)(i) For purposes of paragraph (c)(5) of this section, a transfer 
of stocks and securities will not be treated as resulting in a 
diversification of the transferors' interests if each transferor 
transfers a diversified portfolio of stocks and securities. For purposes 
of this paragraph (c)(6), a portfolio of stocks and securities is 
diversified if it satisfies the 25 and 50-percent tests of section 
368(a)(2)(F)(ii), applying the relevant provisions of section 
368(a)(2)(F). However, Government securities are included in total 
assets for purposes of the denominator of the 25 and 50-percent tests 
(unless the Government securities are acquired to meet the 25 and 50-
percent tests), but are not treated as securities of an issuer for 
purposes of the numerator of the 25 and 50-percent tests.
    (ii) Paragraph (c)(6)(i) of this section is effective for transfers 
completed on or after May 2, 1996. Transfers of diversified (within the 
meaning of paragraph (c)(6)(i) of this section), but nonidentical, 
portfolios of stocks and securities completed before May 2, 1996, may be 
treated either--
    (A) Consistent with paragraph (c)(6)(i) of this section; or
    (B) As resulting in diversification of the transferors' interests.
    (7) The application of subparagraph (5) of this paragraph may be 
illustrated as follows:


[[Page 191]]


    Example 1. Individuals A, B, and C organize a corporation with 101 
shares of common stock. A and B each transfers to it $10,000 worth of 
the only class of stock of corporation X, listed on the New York Stock 
Exchange, in exchange for 50 shares of stock. C transfers $200 worth of 
readily marketable securities in corporation Y for one share of stock. 
In determining whether or not diversification has occurred, C's 
participation in the transaction will be disregarded. There is, 
therefore, no diversification, and gain or loss will not be recognized.
    Example 2. A, together with 50 other transferors, organizes a 
corporation with 100 shares of stock. A transfers $10,000 worth of stock 
in corporation X, listed on the New York Stock Exchange, in exchange for 
50 shares of stock. Each of the other 50 transferors transfers $200 
worth of readily marketable securities in corporations other than X in 
exchange for one share of stock. In determining whether or not 
diversification has occurred, all transfers will be taken into account. 
Therefore, diversification is present, and gain or loss will be 
recognized.

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 6942, 32 FR 
20977, Dec. 29, 1967; T.D. 8665, 61 FR 19189, May 1, 1996; T.D. 8663, 61 
FR 19545, May 2, 1996]



Sec. 1.351-2  Receipt of property.

    (a) If an exchange would be within the provisions of section 351(a) 
if it were not for the fact that the property received in exchange 
consists not only of property permitted by such subsection to be 
received without the recognition of gain, but also of other property or 
money, then the gain, if any, to the recipient shall be recognized, but 
in an amount not in excess of the sum of such money and the fair market 
value of such other property. No loss to the recipient shall be 
recognized.
    (b) See section 357 and the regulations pertaining to that section 
for applicable rules as to the treatment of liabilities as ``other 
property'' in cases subject to section 351, where another party to the 
exchange assumes a liability, or acquires property subject to a 
liability.
    (c) See sections 358 and 362 and the regulations pertaining to those 
sections for applicable rules with respect to the determination of the 
basis of stock, securities, or other property received in exchanges 
subject to section 351.
    (d) See part I (section 301 and following), subchapter C, chapter 1 
of the Code, and the regulations thereunder for applicable rules with 
respect to the taxation of dividends where a distribution by a 
corporation of its stock or securities in connection with an exchange 
subject to section 351(a) has the effect of the distribution of a 
taxable dividend.
    (e) See Sec. 1.356-7(a) for the applicability of the definition of 
nonqualified preferred stock in section 351(g)(2) for stock issued prior 
to June 9, 1997, and for stock issued in transactions occurring after 
June 8, 1997, that are described in section 1014(f)(2) of the Taxpayer 
Relief Act of 1997, Public Law 105-34 (111 Stat. 788, 921). See Sec. 
1.356-7(c) for the treatment of preferred stock received in certain 
exchanges for common or preferred stock described in section 
351(g)(2)(C)(i)(II).

[T.D. 6500, 25 FR 11607, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 8904, 65 FR 58650, Oct. 2, 2000]



Sec. 1.351-3  Records to be kept and information to be filed.

    (a) Significant transferor. Every significant transferor must 
include a statement entitled, ``STATEMENT PURSUANT TO Sec. 1.351-3(a) 
BY [INSERT NAME AND TAXPAYER IDENTIFICATION NUMBER (IF ANY) OF 
TAXPAYER], A SIGNIFICANT TRANSFEROR,'' on or with such transferor's 
income tax return for the taxable year of the section 351 exchange. If a 
significant transferor is a controlled foreign corporation (within the 
meaning of section 957), each United States shareholder (within the 
meaning of section 951(b)) with respect thereto must include this 
statement on or with its return. The statement must include--
    (1) The name and employer identification number (if any) of the 
transferee corporation;
    (2) The date(s) of the transfer(s) of assets;
    (3) The aggregate fair market value and basis, determined 
immediately before the exchange, of the property transferred by such 
transferor in the exchange; and
    (4) The date and control number of any private letter ruling(s) 
issued by the Internal Revenue Service in connection with the section 
351 exchange.

[[Page 192]]

    (b) Transferee corporation. Except as provided in paragraph (c) of 
this section, every transferee corporation must include a statement 
entitled, ``STATEMENT PURSUANT TO Sec. 1.351-3(b) BY [INSERT NAME AND 
EMPLOYER IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A TRANSFEREE 
CORPORATION,'' on or with its income tax return for the taxable year of 
the exchange. If the transferee corporation is a controlled foreign 
corporation (within the meaning of section 957), each United States 
shareholder (within the meaning of section 951(b)) with respect thereto 
must include this statement on or with its return. The statement must 
include--
    (1) The name and taxpayer identification number (if any) of every 
significant transferor;
    (2) The date(s) of the transfer(s) of assets;
    (3) The aggregate fair market value and basis, determined 
immediately before the exchange, of all of the property received in the 
exchange; and
    (4) The date and control number of any private letter ruling(s) 
issued by the Internal Revenue Service in connection with the section 
351 exchange.
    (c) Exception for certain transferee corporations. The transferee 
corporation is not required to file a statement under paragraph (b) of 
this section if all of the information that would be included in the 
statement described in paragraph (b) of this section is included in any 
statement(s) described in paragraph (a) of this section that is attached 
to the same return for the same section 351 exchange.
    (d) Definitions. For purposes of this section:
    (1) Significant transferor means a person that transferred property 
to a corporation and received stock of the transferee corporation in an 
exchange described in section 351 if, immediately after the exchange, 
such person--
    (i) Owned at least five percent (by vote or value) of the total 
outstanding stock of the transferee corporation if the stock owned by 
such person is publicly traded, or
    (ii) Owned at least one percent (by vote or value) of the total 
outstanding stock of the transferee corporation if the stock owned by 
such person is not publicly traded.
    (2) Publicly traded stock means stock that is listed on--
    (i) A national securities exchange registered under section 6 of the 
Securities Exchange Act of 1934 (15 U.S.C. 78f); or
    (ii) An interdealer quotation system sponsored by a national 
securities association registered under section 15A of the Securities 
Exchange Act of 1934 (15 U.S.C. 78o-3).
    (e) Substantiation information. Under Sec. 1.6001-1(e), taxpayers 
are required to retain their permanent records and make such records 
available to any authorized Internal Revenue Service officers and 
employees. In connection with the exchange described in this section, 
these records should specifically include information regarding the 
amount, basis, and fair market value of all transferred property, and 
relevant facts regarding any liabilities assumed or extinguished as part 
of such exchange.
    (f) Effective/applicability date. This section applies to any 
taxable year beginning on or after May 30, 2006. However, taxpayers may 
apply this section to any original Federal income tax return (including 
any amended return filed on or before the due date (including 
extensions) of such original return) timely filed on or after May 30, 
2006. For taxable years beginning before May 30, 2006, see Sec. 1.351-3 
as contained in 26 CFR part 1 in effect on April 1, 2006.

[T.D. 9329, 72 FR 32798, June 14, 2007]

              effects on shareholders and security holders



Sec. 1.354-1  Exchanges of stock and securities in certain reorganizations.

    (a) Section 354 provides that under certain circumstances no gain or 
loss is recognized to a shareholder who surrenders his stock in exchange 
for other stock or to a security holder who surrenders his securities in 
exchange for stock. Section 354 also provides that under certain 
circumstances a security holder may surrender securities and receive 
securities in the same principal amount or in a lesser principal amount 
without the recognition of gain or loss

[[Page 193]]

to him. The exchanges to which section 354 applies must be pursuant to a 
plan of reorganization as provided in section 368(a) and the stock and 
securities surrendered as well as the stock and securities received must 
be those of a corporation which is a party to the reorganization. 
Section 354 does not apply to exchanges pursuant to a reorganization 
described in section 368(a)(1)(D) unless the transferor corporation--
    (1) Transfers all or substantially all of its assets to a single 
corporation, and
    (2) Distributes all of its remaining properties (if any) and the 
stock, securities and other properties received in the exchange to its 
shareholders or security holders in pursuance of the plan of 
reorganization. The fact that properties retained by the transferor 
corporation, or received in exchange for the properties transferred in 
the reorganization, are used to satisfy existing liabilities not 
represented by securities and which were incurred in the ordinary course 
of business before the reorganization does not prevent the application 
of section 354 to an exchange pursuant to a plan of reorganization 
defined in section 368(a)(1)(D).
    (b) Except as provided in section 354 (c) and (d), section 354 is 
not applicable to an exchange of stock or securities if a greater 
principal amount of securities is received than the principal amount of 
securities the recipient surrenders, or if securities are received and 
the recipient surrenders no securities. See, however, section 356 and 
regulations pertaining to such section. See also section 306 with 
respect to the receipt of preferred stock in a transaction to which 
section 354 is applicable.
    (c) An exchange of stock or securities shall be subject to section 
354(a)(1) even though--
    (1) Such exchange is not pursuant to a plan of reorganization 
described in section 368(a), and
    (2) The principal amount of the securities received exceeds the 
principal amount of the securities surrendered or if securities are 
received and no securities are surrendered--

if such exchange is pursuant to a plan of reorganization for a railroad 
corporation as defined in section 77(m) of the Bankruptcy Act (11 U.S.C. 
205(m)) and is approved by the Interstate Commerce Commission under 
section 77 of such act or under section 20b of the Interstate Commerce 
Act (49 U.S.C. 20b) as being in the public interest. Section 354 is not 
applicable to such exchanges if there is received property other than 
stock or securities. See, however, section 356 and regulations 
pertaining to such section.
    (d) The rules of section 354 may be illustrated by the following 
examples:

    Example 1. Pursuant to a reorganization under section 368(a) to 
which Corporations T and W are parties, A, a shareholder in Corporation 
T, surrenders all his common stock in Corporation T in exchange for 
common stock of Corporation W. No gain or loss is recognized to A.
    Example 2. Pursuant to a reorganization under section 368(a) to 
which Corporations X and Y (which are not railroad corporations) are 
parties, B, a shareholder in Corporation X, surrenders all his stock in 
X for stock and securities in Y. Section 354 does not apply to this 
exchange. See, however, section 356.
    Example 3. C, a shareholder in Corporation Z (which is not a 
railroad corporation), surrenders all his stock in Corporation Z in 
exchange for securities in Corporation Z. Whether or not this exchange 
is in connection with a recapitalization under section 368(a)(1)(E), 
section 354 does not apply. See, however, section 302.
    Example 4. The facts are the same as in Example 3 of this paragraph 
(d), except that C receivies solely rights to acquire stock in 
Corporation Z. Section 354 does not apply.

    (e) Except as provided in Sec. 1.356-6, for purposes of section 
354, the term securities includes rights issued by a party to the 
reorganization to acquire its stock. For purposes of this section and 
section 356(d)(2)(B), a right to acquire stock has no principal amount. 
For this purpose, rights to acquire stock has the same meaning as it 
does under sections 305 and 317(a). Other Internal Revenue Code 
provisions governing the treatment of rights to acquire stock may also 
apply to certain exchanges occurring in connection with a 
reorganization. See, for example, sections 83 and 421 through 424 and 
the regulations thereunder. This paragraph (e) applies to exchanges 
occurring on or after March 9, 1998.
    (f) See Sec. 1.356-7(a) and (b) for the treatment of nonqualified 
preferred stock (as defined in section 351(g)(2))

[[Page 194]]

received in certain exchanges for nonqualified preferred stock or 
preferred stock. See Sec. 1.356-7(c) for the treatment of preferred 
stock received in certain exchanges for common or preferred stock 
described in section 351(g)(2)(C)(i)(II).

[T.D. 6500, 25 FR 11607, Nov. 26, 1960, as amended by T.D. 7616, 44 FR 
26869, May 8, 1979; T.D. 8752, 63 FR 410, Jan. 6, 1998; T.D. 8882, 65 FR 
31078, May 16, 2000; T.D. 8904, 65 FR 58651, Oct. 2, 2000]



Sec. 1.355-0  Outline of sections.

    In order to facilitate the use of Sec. Sec. 1.355-1 through 1.355-
7, this section lists the major paragraphs in those sections as follows:

   Sec. 1.355-1 Distribution of stock and securities of a controlled 
                              corporation.

    (a) Effective date of certain sections.
    (b) Application of section.

                       Sec. 1.355-2 Limitations.

    (a) Property distributed.
    (b) Independent business purpose.
    (1) Independent business purpose requirement.
    (2) Corporate business purpose.
    (3) Business purpose for distribution.
    (4) Business purpose as evidence of nondevice.
    (5) Examples.
    (c) Continuity of interest requirement.
    (1) Requirement.
    (2) Examples.
    (d) Device for distribution of earnings and profits.
    (1) In general.
    (2) Device factors.
    (i) In general.
    (ii) Pro rata distribution.
    (iii) Subsequent sale or exchange of stock.
    (A) In general.
    (B) Sale or exchange negotiated or agreed upon before the 
distribution.
    (C) Sale or exchange not negotiated or agreed upon before the 
distribution.
    (D) Negotiated or agreed upon before the distribution.
    (E) Exchange in pursuance of a plan of reorganization.
    (iv) Nature and use of assets.
    (A) In general.
    (B) Assets not used in a trade or business meeting the requirement 
of section 355(b).
    (C) Related function.
    (3) Nondevice factors.
    (i) In general.
    (ii) Corporate business purpose.
    (iii) Distributing corporation publicly traded and widely held.
    (iv) Distribution to domestic corporate shareholders.
    (4) Examples.
    (5) Transactions ordinarily not considered as a device.
    (i) In general.
    (ii) Absence of earnings and profits.
    (iii) Section 303(a) transactions.
    (iv) Section 302(a) transactions.
    (v) Examples.
    (e) Stock and securities distributed.
    (1) In general.
    (2) Additional rules.
    (f) Principal amount of securities.
    (1) Securities received.
    (2) Only stock received.
    (g) [Reserved]
    (h) Active conduct of a trade or business.
    (i) [Reserved]

          Sec. 1.355-3 Active conduct of a trade or business.

    (a) General requirements.
    (1) Application of section 355.
    (2) Examples.
    (b) Active conduct of a trade or business defined.
    (1) In general.
    (2) Active conduct or a trade or business immediately after 
distribution.
    (i) In general.
    (ii) Trade or business.
    (iii) Active conduct.
    (iv) Limitations.
    (3) Active conduct for five-year period preceding distribution.
    (4) Special rules for acquisition of a trade or business (Prior to 
the Revenue Act of 1987 and Technical and Miscellaneous Revenue Act of 
1988).
    (i) In general.
    (ii) Example.
    (iii) Gain or loss recognized in certain transactions.
    (iv) Affiliated group.
    (5) Special rules for acquisition of a trade or business (After the 
Revenue Act of 1987 and Technical and Miscellaneous Revenue Act of 
1988).
    (c) Examples.

             Sec. 1.355-4 Non pro rata distributions, etc.

      Sec. 1.355-5 Records to be kept and information to be filed.

    (a) Distributing corporation.
    (1) In general.
    (2) Special rule when an asset transfer precedes a stock 
distribution.
    (b) Significant distributee.
    (c) Definitions.
    (1) Significant distributee.
    (2) Publicly traded stock.
    (d) Substantiation information.
    (e) Effective/applicability date.

[[Page 195]]

 Sec. 1.355-6 Recognition of gain on certain distributions of stock or 
                  securities in controlled corporation.

    (a) Conventions.
    (1) Examples.
    (2) Five-year period.
    (3) Distributing securities.
    (4) Marketable securities.
    (b) General rules and purposes of section 355(d).
    (1) Disqualified distributions in general.
    (2) Disqualified stock.
    (i) In general.
    (ii) Purchase.
    (iii) Exceptions.
    (A) Purchase eliminated.
    (B) Deemed purchase eliminated.
    (C) Elimination of basis.
    (1) General rule.
    (2) Special rule for transferred and exchanged basis property.
    (3) Special rule for Split-offs and Split-ups.
    (D) Special rule if basis allocated between two corporations.
    (3) Certain distributions not disqualified distributions because 
purposes of section 355(d) not violated.
    (i) In general.
    (ii) Disqualified person.
    (iii) Purchased basis.
    (iv) Increase in interest because payment of cash in lieu of 
fractional shares.
    (v) Other exceptions.
    (vi) Examples.
    (4) Anti-avoidance rule.
    (i) In general.
    (ii) Example.
    (c) Whether a person holds a 50 percent or greater interest.
    (1) In general.
    (2) Valuation.
    (3) Effect of options, warrants, convertible obligations, and other 
similar interests.
    (i) Application.
    (ii) General rule.
    (iii) Options deemed newly issued and substituted options.
    (A) Exchange, adjustment, or alteration of existing option.
    (B) Certain compensatory options.
    (C) Substituted options.
    (iv) Effect of treating an option as exercised.
    (A) In general.
    (B) Stock purchase agreement or similar arrangement.
    (v) Instruments treated as options.
    (vi) Instruments generally not treated as options.
    (A) Escrow, pledge, or other security agreements.
    (B) Compensatory options.
    (1) General rule.
    (2) Exception.
    (C) Certain stock conversion features.
    (D) Options exercisable only upon death, disability, mental 
imcompetency, or separation from service.
    (E) Rights of first refusal.
    (F) Other enumerated instruments.
    (vii) Reasonably certain that the option will be exercised.
    (A) In general.
    (B) Stock purchase agreement or similar arrangement.
    (viii) Examples.
    (4) Plan or arrangement.
    (i) In general.
    (ii) Understanding.
    (iii) Examples.
    (iv) Exception.
    (A) Subsequent disposition.
    (B) Example.
    (d) Purchase.
    (1) In general.
    (i) Definition of purchase under section 355(d)(5)(A).
    (ii) Section 355 distributions.
    (iii) Example.
    (2) Exceptions to definition of purchase under section 355(d)(5)(A).
    (i) Acquisition of stock in a transaction which includes other 
property or money.
    (A) Transferors and shareholders of transferor or distributing 
corporations.
    (1) In general.
    (2) Exception.
    (B) Transferee corporations.
    (1) In general.
    (2) Exception.
    (C) Examples.
    (ii) Acquisition of stock in a distribution to which section 305(a) 
applies.
    (iii) Section 1036(a) exchange.
    (iv) Section 338 elections.
    (A) In general.
    (B) Example.
    (v) Partnership distributions.
    (A) Section 732(b).
    (B) Section 734(b).
    (3) Certain section 351 exchanges treated as purchases.
    (i) In general.
    (A) Treatment of stock received by transferor.
    (B) Multiple classes of stock.
    (ii) Cash item, marketable stock.
    (iii) Exception for certain acquisitions.
    (A) In general.
    (B) Example.
    (iv) Exception for assets transferred as part of an active trade or 
business.
    (A) In general.
    (B) Active conduct of a trade or business.
    (C) Reasonable needs of the trade or business.
    (D) Consideration of all facts and circumstances.
    (E) Successive transfers.
    (v) Exception for transfer between members of the same affiliated 
group.
    (A) In general.

[[Page 196]]

    (B) Examples.
    (4) Triangular asset reorganizations.
    (i) Definition.
    (ii) Treatment.
    (iii) Example.
    (5) Reverse triangular reorganizations other than triangular asset 
reorganizations.
    (i) In general.
    (ii) Letter ruling and closing agreement.
    (iii) Example.
    (6) Treatment of group structure changes.
    (i) In general.
    (ii) Adjustments to basis of higher-tier members.
    (iii) Example.
    (7) Special rules for triangular asset reorganizations, other 
reverse triangular reorganizations, and group structure changes.
    (e) Deemed purchase and timing rules.
    (1) Attribution and aggregation.
    (i) In general.
    (ii) Purchase of additional interest.
    (iii) Purchase between persons treated as one person.
    (iv) Purchase by a person already treated as holding stock under 
section 355(d)(8)(A).
    (v) Examples.
    (2) Transferred basis rule.
    (3) Exchanged basis rule.
    (i) In general.
    (ii) Example.
    (4) Certain section 355 or section 305 distributions.
    (i) Section 355.
    (ii) Section 305.
    (5) Substantial diminution of risk.
    (i) In general.
    (ii) Property to which suspension applies.
    (iii) Risk of loss substantially diminished.
    (iv) Special class of stock.
    (f) Duty to determine stockholders.
    (1) In general.
    (2) Deemed knowledge of contents of securities filings.
    (3) Presumptions as to securities filings.
    (4) Presumption as to less-than-five-percent shareholders.
    (5) Examples.
    (g) Effective date.

 Sec. 1.355-7 Recognition of gain on certain distributions of stock or 
              securities in connection with an acquisition.

    (a) In general.
    (b) Plan.
    (1) In general.
    (2) Certain post-distribution acquisitions.
    (3) Plan factors.
    (4) Non-plan factors.
    (c) Operating rules.
    (1) Internal discussions and discussions with outside advisors 
evidence of business purpose.
    (2) Takeover defense.
    (3) Effect of distribution on trading in stock.
    (4) Consequences of section 355(e) disregarded for certain purposes.
    (5) Multiple acquisitions.
    (d) Safe harbors.
    (1) Safe Harbor I.
    (2) Safe Harbor II.
    (i) In general.
    (ii) Special rule.
    (3) Safe Harbor III.
    (4) Safe Harbor IV.
    (i) In general.
    (ii) Special rules.
    (5) Safe Harbor V.
    (i) In general.
    (ii) Special rules.
    (6) Safe Harbor VI.
    (7) Safe Harbor VII.
    (i) In general.
    (ii) Special rules.
    (8) Safe Harbor VIII.
    (i) In general.
    (ii) Special rule.
    (9) Safe Harbor IX.
    (i) In general.
    (ii) Special rule.
    (e) Options, warrants, convertible obligations, and other similar 
interests.
    (1) Treatment of options.
    (i) General rule.
    (ii) Agreement, understanding, or arrangement to write, transfer, or 
modify an option.
    (iii) Substantial negotiations related to options.
    (2) Stock acquired pursuant to options.
    (3) Instruments treated as options.
    (4) Instruments generally not treated as options.
    (i) Escrow, pledge, or other security agreements.
    (ii) Options exercisable only upon death, disability, mental 
incompetency, or separation from service.
    (iii) Rights of first refusal.
    (iv) Other enumerated instruments.
    (f) Multiple controlled corporations.
    (g) Valuation.
    (h) Definitions.
    (1) Agreement, understanding, arrangement, or substantial 
negotiations.
    (2) Controlled corporation.
    (3) Controlling shareholder.
    (4) Coordinating group.
    (5) Disclosure event.
    (6) Discussions.
    (7) Established market.
    (8) Five-percent shareholder.
    (9) Implicit permission.
    (10) Public announcement.
    (11) Public offering.
    (12) Similar acquisition (not involving a public offering).
    (13) Similar acquisition involving a public offering.
    (i) One public offering.
    (ii) More than one public offering.
    (iii) Potential acquisition involving a public offering.

[[Page 197]]

    (14) Ten-percent shareholder.
    (i) [Reserved]
    (j) Examples.
    (k) Effective dates.

[T.D. 8238, 54 FR 289, Jan. 5, 1989, as amended by T.D. 8913, 65 FR 
79722, Dec. 20, 2000; T.D. 8960, 66 FR 40591, Aug. 3, 2001; T.D. 8988, 
67 FR 20636, Apr. 26, 2002; 67 FR 38200, June 3, 2002; T.D. 9198, 70 FR 
20283, Apr. 19, 2005; T.D. 9264, 71 FR 30597, May 30, 2006; T.D. 9329, 
72 FR 32799, June 14, 2007; T.D. 9435, 73 FR 75950, Dec. 15, 2008]



Sec. 1.355-0T  Outline of sections (temporary).

    This section lists the major paragraphs under Sec. 1.355-2T.

                 Sec. 1.355-2T Limitations (temporary).

    (a) through (f)(2) [Reserved] For further guidance, see the entries 
for Sec. 1.355-2(a) through (f)(2) in Sec. 1.355-0.
    (g) Recently acquired controlled stock under section 355(a)(3)(B).
    (1) Other property.
    (2) Exceptions.
    (3) DSAG.
    (4) Taxable transaction.
    (5) Examples.
    (h) [Reserved] For further guidance, see the entry for Sec. 1.355-
2(h) in Sec. 1.355-0.
    (i) Effective/applicability date.
    (1) In general.
    (2) Transition election.
    (3) Retroactive election.
    (4) Manner of election.
    (5) Prior law.
    (6) Expiration date.

[T.D. 9435, 73 FR 75950, Dec. 15, 2008]



Sec. 1.355-1  Distribution of stock and securities of a controlled corporation.

    (a) Effective/applicability date of certain sections. Except as 
otherwise provided, this section and Sec. Sec. 1.355-2 through 1.355-4 
apply to transactions occurring after February 6, 1989. For transactions 
occurring on or before that date, see 26 CFR 1.355-1 through 1.355-4 
(revised as of April 1, 1987). This section and Sec. Sec. 1.355-2 
through 1.355-4, other than Sec. Sec. 1.355-2(g) and (i) and 1.355-2T, 
do not reflect the amendments to section 355 made by the Revenue Act of 
1987, the Technical and Miscellaneous Revenue Act of 1988, and the Tax 
Technical Corrections Act of 2007. For the applicability date of 
Sec. Sec. 1.355-2T(g), 1.355-5, 1.355-6, and 1.355-7, see Sec. Sec. 
1.355-2T(i), 1.355-5(e), 1.355-6(g), and 1.355-7(k), respectively.
    (b) Application of section. Section 355 provides for the separation, 
without recognition of gain or loss to (or the inclusion in income of) 
the shareholders and security holders, of one or more existing 
businesses formerly operated, directly or indirectly, by a single 
corporation (the ``distributing corporation''). It applies only to the 
separation of existing businesses that have been in active operation for 
at least five years (or a business that has been in active operation for 
at least five years into separate businesses), and which, in general, 
have been owned, directly or indirectly, for at least five years by the 
distributing corporation. A separation is achieved through the 
distribution by the distributing corporation of stock, or stock and 
securities, of one or more subsidiaries (the ``controlled 
corporations'') to its shareholders with respect to its stock or to its 
security holders in exchange for its securities. The controlled 
corporations may be preexisting or newly created subsidiaries. 
Throughout the regulations under section 355, the term distribution 
refers to a distribution by the distributing corporation of stock, or 
stock and securities, of one or more controlled corporations, unless the 
context indicates otherwise. Section 355 contemplates the continued 
operation of the business or businesses existing prior to the 
separation. See Sec. 1.355-4 for types of distributions that may 
qualify under section 355, including pro rata distributions and non pro 
rata distributions.
    (c) Stock rights. Except as provided in Sec. 1.356-6, for purposes 
of section 355, the term securities includes rights issued by the 
distributing corporation or the controlled corporation to acquire the 
stock of that corporation. For purposes of this section and section 
356(d)(2)(B), a right to acquire stock has no principal amount. For this 
purpose, rights to acquire stock has the same meaning as it does under 
sections 305 and 317(a). Other Internal Revenue Code provisions 
governing the treatment of rights to acquire stock may also apply to 
certain distributions occurring in connection with a transaction 
described in section 355. See, for example, sections 83 and 421 through 
424 and the regulations thereunder. This paragraph (c)

[[Page 198]]

applies to distributions occurring on or after March 9, 1998.
    (d) Nonqualified preferred stock. See Sec. 1.356-7(a) and (b) for 
the treatment of nonqualified preferred stock (as defined in section 
351(g)(2)) received in certain exchanges for (or in certain 
distributions with respect to) nonqualified preferred stock or preferred 
stock. See Sec. 1.356-7(c) for the treatment of the receipt of 
preferred stock in certain exchanges for (or in certain distributions 
with respect to) common or preferred stock described in section 
351(g)(2)(C)(i)(II).

[T.D. 8238, 54 FR 289, Jan. 5, 1989, as amended by T.D. 8752, 63 FR 410, 
Jan. 6, 1998; T.D. 8882, 65 FR 31078, May 16, 2000; T.D. 8904, 65 FR 
58651, Oct. 2, 2000; T.D. 9435, 73 FR 75950, Dec. 15, 2008; 74 FR 3420, 
Jan. 21, 2009]



Sec. 1.355-2  Limitations.

    (a) Property distributed. Section 355 applies to a distribution only 
if the property distributed consists solely of stock, or stock and 
securities, of a controlled corporation. If additional property 
(including an excess principal amount of securities received over 
securities surrendered) is received, see section 356.
    (b) Independent business purpose--(1) Independent business purpose 
requirement. Section 355 applies to a transaction only if it is carried 
out for one or more corporate business purposes. A transaction is 
carried out for a corporate business purpose if it is motivated, in 
whole or substantial part, by one or more corporate business purposes. 
The potential for the avoidance of Federal taxes by the distributing or 
controlled corporations (or a corporation controlled by either) is 
relevant in determining the extent to which an existing corporate 
business purpose motivated the distribution. The principal reason for 
this business purpose requirement is to provide nonrecognition treatment 
only to distributions that are incident to readjustments of corporate 
structures required by business exigencies and that effect only 
readjustments of continuing interests in property under modified 
corporate forms. This business purpose requirement is independent of the 
other requirements under section 355.
    (2) Corporate business purpose. A corporate business purpose is a 
real and substantial non Federal tax purpose germane to the business of 
the distributing corporation, the controlled corporation, or the 
affiliated group (as defined in Sec. 1.355-3(b)(4)(iv)) to which the 
distributing corporation belongs. A purpose of reducing non Federal 
taxes is not a corporate business purpose if (i) the transaction will 
effect a reduction in both Federal and non Federal taxes because of 
similarities between Federal tax law and the tax law of the other 
jurisdiction and (ii) the reduction of Federal taxes is greater than or 
substantially coextensive with the reduction of non Federal taxes. See 
Examples (7) and (8) of paragraph (b)(5) of this section. A shareholder 
purpose (for example, the personal planning purposes of a shareholder) 
is not a corporate business purpose. Depending upon the facts of a 
particular case, however, a shareholder purpose for a transaction may be 
so nearly coextensive with a corporate business purpose as to preclude 
any distinction between them. In such a case, the transaction is carried 
out for one or more corporate business purposes. See Example (2) of 
paragraph (b)(5) of this section.
    (3) Business purpose for distribution. The distribution must be 
carried out for one or more corporate business purposes. See Example (3) 
of paragraph (b)(5) of this section. If a corporate business purpose can 
be achieved through a nontaxable transaction that does not involve the 
distribution of stock of a controlled corporation and which is neither 
impractical nor unduly expensive, then, for purposes of paragraph (b)(1) 
of this section, the separation is not carried out for that corporate 
business purpose. See Examples (3) and (4) of paragraph (b)(5) of this 
section. For rules with respect to the requirement of a business purpose 
for a transfer of assets to a controlled corporation in connection with 
a reorganization described in section 368(a)(1)(D), See Sec. 1.368-
1(b).
    (4) Business purpose as evidence of nondevice. The corporate 
business purpose or purposes for a transaction are evidence that the 
transaction was not used principally as a device for the distribution of 
earnings and profits within

[[Page 199]]

the meaning of section 355(a)(1)(B). See paragraph (d)(3)(ii) of this 
section.
    (5) Examples. The provisions of this paragraph (b) may be 
illustrated by the following examples:

    Example 1. Corporation X is engaged in the production, 
transportation, and refining of petroleum products. In 1985, X acquires 
all of the properties of corporation Z, which is also engaged in the 
production, transportation, and refining of petroleum products. In 1991, 
as a result of antitrust litigation, X is ordered to divest itself of 
all of the properties acquired from Z. X transfers those properties to 
new corporation Y and distributes the stock of Y pro rata to X's 
shareholders. In view of the divestiture order, the distribution is 
carried out for a corporate business purpose. See paragraph (b)(1) of 
this section.
    Example 2. Corporation X is engaged in two businesses: The 
manufacture and sale of furniture and the sale of jewelry. The 
businesses are of equal value. The outstanding stock of X is owned 
equally by unrelated individuals A and B. A is more interested in the 
furniture business, while B is more interested in the jewelry business. 
A and B decide to split up the businesses and go their separate ways. A 
and B anticipate that the operations of each business will be enhanced 
by the separation because each shareholder will be able to devote his 
undivided attention to the business in which he is more interested and 
more proficient. Accordingly, X transfers the jewelry business to new 
corporation Y and distributes the stock of Y to B in exchange for all of 
B's stock in X. The distribution is carried out for a corporate business 
purpose, notwithstanding that it is also carried out in part for 
shareholder purposes. See paragraph (b)(2) of this section.
    Example 3. Corporation X is engaged in the manufacture and sale of 
toys and the manufacture and sale of candy. The shareholders of X wish 
to protect the candy business from the risks and vicissitudes of the toy 
business. Accordingly, X transfers the toy business to new corporation Y 
and distributes the stock of Y to X's shareholders. Under applicable 
law, the purpose of protecting the candy business from the risks and 
vicissitudes of the toy business is achieved as soon as X transfers the 
toy business to Y. Therefore, the distribution is not carried out for a 
corporate business purpose. See paragraph (b)(3) of this section.
    Example 4. Corporation X is engaged in a regulated business in State 
T. X owns all of the stock of corporation Y, a profitable corporation 
that is not engaged in a regulated business. Commission C sets the rates 
that X may charge its customers, based on its total income. C has 
recently adopted rules according to which the total income of a 
corporation includes the income of a business if, and only if, the 
business is operated, directly or indirectly, by the corporation. Total 
income, for this purpose, includes the income of a wholly owned 
subsidiary corporation but does not include the income of a parent or 
``brother/sister'' corporation. Under C's new rule, X's total income 
includes the income of Y, with the result that X has suffered a 
reduction of the rates that it may charge its customers. It would not be 
impractical or unduly expensive to create in a nontaxable transaction 
(such as a transaction qualifying under section 351) a holding company 
to hold the stock of X and Y. X distributes the stock of Y to X's 
shareholders. The distribution is not carried out for the purpose of 
increasing the rates that X may charge its customers because that 
purpose could be achieved through a nontaxable transaction, the creation 
of a holding company, that does not involve the distribution of stock of 
a controlled corporation and which is neither impractical nor unduly 
expensive. See paragraph (b)(3) of this section.
    Example 5. The facts are the same as in Example (4), except that C 
has recently adopted rules according to which the total income of a 
corporation includes not only the income included in Example (3), but 
also the income of any member of the affiliated group to which the 
corporation belongs. In order to avoid a reduction in the rates that it 
may charge its customers, X distributes the stock of Y to X's 
shareholders. The distribution is carried out for a corporate business 
purpose. See paragraph (b)(3) of this section.
    Example 6. (i) Corporation X owns all of the one class of stock of 
corporation Y. X distributes the stock of Y pro rata to its five 
shareholders, all of whom are individuals, for the sole purpose of 
enabling X and/or Y to elect to become an S corporation. The 
distribution does not meet the corporate business purpose requirement. 
See paragraph (b)(1) and (2) of this section.
    (ii) The facts are the same as in Example 6(i), except that the 
business of Y is operated as a division of X. X transfers this division 
to new corporation Y and distributes the stock of Y pro rata to its 
shareholders, all of whom are individuals, for the sole purpose of 
enabling X and/or Y to elect to become an S corporation. The 
distribution does not meet the corporate business purpose requirement. 
See paragraph (b)(1) and (2) of this section.
    Example 7. The facts are the same as in Example (6)(i), except that 
the distribution is made to enable X to elect to become an S corporation 
both for Federal tax purposes and for purposes of the income tax imposed 
by State M. State M has tax law provisions similar to subchapter S of 
the Internal Revenue Code of 1986. An election to be an S corporation 
for Federal tax purposes will effect a substantial reduction in Federal 
taxes that is greater than the reduction of State M taxes pursuant to an 
election to be an S corporation for State M purposes. The purpose

[[Page 200]]

of reducing State M taxes is not a corporate business purpose. The 
distribution does not meet the corporate business purpose requirements. 
See paragraph (b)(1) and (2) of this section.
    Example 8. The facts are the same as Example (7), except that the 
distribution also is made to enable A, a key employee of Y, to acquire 
stock of Y without investing in X. A is considered to be critical to the 
success of Y and he has indicated that he will seriously consider 
leaving the company if he is not given the opportunity to purchase a 
significant amount of stock of Y. As a matter of state law, Y could not 
issue stock to the employee while it was a subsidiary of X. As in 
Example (7), the purpose of reducing State M taxes is not a corporate 
business purpose. In order to determine whether the issuance of stock to 
the key employee, in fact, motivated the distribution of the Y stock, 
the potential avoidance of Federal taxes is a relevant factor to take 
into account. If the facts and circumstances establish that the 
distribution was substantially motivated by the need to issue stock to 
the employee, the distribution will meet the corporate business purpose 
requirement.

    (c) Continuity of interest requirement--(1) Requirement. Section 355 
applies to a separation that effects only a readjustment of continuing 
interests in the property of the distributing and controlled 
corporations. In this regard section 355 requires that one or more 
persons who, directly or indirectly, were the owners of the enterprise 
prior to the distribution or exchange own, in the aggregate, an amount 
of stock establishing a continuity of interest in each of the modified 
corporate forms in which the enterprise is conducted after the 
separation. This continuity of interest requirement is independent of 
the other requirements under section 355.
    (2) Examples.

    Example 1. For more than five years, corporation X has been engaged 
directly in one business, and indirectly in a different business through 
its wholly owned subsidiary, S. The businesses are equal in value. At 
all times, the outstanding stock of X has been owned equally by 
unrelated individuals A and B. For valid business reasons, A and B cause 
X to distribute all of the stock of S to B in exchange for all of B's 
stock in X. After the transaction, A owns all the stock of X and B owns 
all the stock of S. The continuity of interest requirement is met 
because one or more persons who were the owners of X prior to the 
distribution (A and B) own, in the aggregate, an amount of stock 
establishing a continuity of interest in each of X and S after the 
distribution.
    Example 2. Assume the same facts as in Example (1), except that 
pursuant to a plan to acquire a stock interest in X without acquiring, 
directly or indirectly, an interest in S, C purchased one-half of the X 
stock owned by A and immediately thereafter X distributed all of the S 
stock to B in exchange for all of B's stock in X. After the 
transactions, A owns 50 percent of X and B owns 100 percent of S. The 
distribution by X of all of the stock of S to B in exchange for all of 
B's stock in X will satisfy the continuity of interest requirement for 
section 355 because one or more persons who were the owners of X prior 
to the distribution (A and B) own, in the aggregate, an amount of stock 
establishing a continuity of interest in each of X and S after the 
distribution.
    Example 3. Assume the same facts as in Examples (1) and (2), except 
that C purchased all of the X stock owned by A. After the transactions, 
neither A nor B own any of the stock of X, and B owns all the stock of 
S. The continuity of interest requirement is not met because the owners 
of X prior to the distribution (A and B) do not, in the aggregate, own 
an amount of stock establishing a continuity of interest in each of X 
and S after the distribution, i.e., although A and B collectively have 
retained 50 percent of their equity interest in the former combined 
enterprise, they have failed to continue to own the minimum stock 
interest in the distributing corporation, X, that would be required in 
order to meet the continuity of interest requirement.
    Example 4. Assume the same facts as in Examples (1) and (2), except 
that C purchased 80 percent of the X stock owned by A. After the 
transactions, A owns 20 percent of the stock of X, B owns no X stock, 
and B owns 100 percent of the S stock. The continuity of interest 
requirement is not met because the owners of X prior to the distribution 
(A and B) do not, in the aggregate, have a continuity of interest in 
each of X and S after the distribution, i.e., although A and B 
collectively have retained 60 percent of their equity interest in the 
former combined enterprise, the 20 percent interest of A in X is less 
than the minimum equity interest in the distributing corporation, X, 
that would be required in order to meet the continuity of interest 
requirement.

    (d) Device for distribution of earnings and profits--(1) In general. 
Section 355 does not apply to a transaction used principally as a device 
for the distribution of the earnings and profits of the distributing 
corporation, the controlled corporation, or both (a ``device''). Section 
355 recognizes that a tax-free distribution of the stock of a

[[Page 201]]

controlled corporation presents a potential for tax avoidance by 
facilitating the avoidance of the dividend provisions of the Code 
through the subsequent sale or exchange of stock of one corporation and 
the retention of the stock of another corporation. A device can include 
a transaction that effects a recovery of basis. In this paragraph (d), 
``exchange'' includes transactions, such as redemptions, treated as 
exchanges under the Code. Generally, the determination of whether a 
transaction was used principally as a device will be made from all of 
the facts and circumstances, including, but not limited to, the presence 
of the device factors specified in paragraph (d)(2) of this section 
(``evidence of device''), and the presence of the nondevice factors 
specified in paragraph (d)(3) of this section (``evidence of 
nondevice''). However, if a transaction is specified in paragraph (d)(5) 
of this section, then it is ordinarily considered not to have been used 
principally as a device.
    (2) Device factors--(i) In general. The presence of any of the 
device factors specified in this subparagraph (2) is evidence of device. 
The strength of this evidence depends on the facts and circumstances.
    (ii) Pro rata distribution. A distribution that is pro rata or 
substantially pro rata among the shareholders of the distributing 
corporation presents the greatest potential for the avoidance of the 
dividend provisions of the Code and, in contrast to other types of 
distributions, is more likely to be used principally as a device. 
Accordingly, the fact that a distribution is pro rata or substantially 
pro rata is evidence of device.
    (iii) Subsequent sale or exchange of stock--(A) In general. A sale 
or exchange of stock of the distributing or the controlled corporation 
after the distribution (a ``subsequent sale or exchange'') is evidence 
of device. Generally, the greater the percentage of the stock sold or 
exchanged after the distribution, the stronger the evidence of device. 
In addition, the shorter the period of time between the distribution and 
the sale or exchange, the stronger the evidence of device.
    (B) Sale or exchange negotiated or agreed upon before the 
distribution. A subsequent sale or exchange pursuant to an arrangement 
negotiated or agreed upon before the distribution is substantial 
evidence of device.
    (C) Sale or exchange not negotiated or agreed upon before the 
distribution. A subsequent sale or exchange not pursuant to an 
arrangement negotiated or agreed upon before the distribution is 
evidence of device.
    (D) Negotiated or agreed upon before the distribution. For purposes 
of this subparagraph (2), a sale or exchange is always pursuant to an 
arrangement negotiated or agreed upon before the distribution if 
enforceable rights to buy or sell existed before the distribution. If a 
sale or exchange was discussed by the buyer and the seller before the 
distribution and was reasonably to be anticipated by both parties, then 
the sale or exchange will ordinarily be considered to be pursuant to an 
arrangement negotiated or agreed upon before the distribution.
    (E) Exchange in pursuance of a plan of reorganization. For purposes 
of this subparagraph (2), if stock is exchanged for stock in pursuance 
of a plan of reorganization, and either no gain or loss or only an 
insubstantial amount of gain is recognized on the exchange, then the 
exchange is not treated as a subsequent sale or exchange, but the stock 
received in the exchange is treated as the stock surrendered in the 
exchange. For this purpose, gain treated as a dividend pursuant to 
sections 356(a)(2) and 316 shall be disregarded.
    (iv) Nature and use of assets--(A) In general. The determination of 
whether a transaction was used principally as a device will take into 
account the nature, kind, amount, and use of the assets of the 
distributing and the controlled corporations (and corporations 
controlled by them) immediately after the transaction.
    (B) Assets not used in a trade or business meeting the requirement 
of section 355(b). The existence of assets that are not used in a trade 
or business that satisfies the requirements of section 355(b) is 
evidence of device. For this purpose, assets that are not used in a 
trade or business that satisfies the requirements of section 355(b) 
include,

[[Page 202]]

but are not limited to, cash and other liquid assets that are not 
related to the reasonable needs of a business satisfying such section. 
The strength of the evidence of device depends on all the facts and 
circumstances, including, but not limited to, the ratio for each 
corporation of the value of assets not used in a trade or business that 
satisfies the requirements of section 355(b) to the value of its 
business that satisfies such requirements. A difference in the ratio 
described in the preceding sentence for the distributing and controlled 
corporation is ordinarily not evidence of device if the distribution is 
not pro rata among the shareholders of the distributing corporation and 
such difference is attributable to a need to equalize the value of the 
stock distributed and the value of the stock or securities exchanged by 
the distributees.
    (C) Related function. There is evidence of device if a business of 
either the distributing or controlled corporation (or a corporation 
controlled by it) is (1) a ``secondary business'' that continues as a 
secondary business for a significant period after the separation, and 
(2) can be sold without adversely affecting the business of the other 
corporation (or a corporation controlled by it). A secondary business is 
a business of either the distributing or controlled corporation, if its 
principal function is to serve the business of the other corporation (or 
a corporation controlled by it). A secondary business can include a 
business transferred to a newly-created subsidiary or a business which 
serves a business transferred to a newly-created subsidiary. The 
activities of the secondary business may consist of providing property 
or performing services. Thus, in Example (11) of Sec. 1.355-3(c), 
evidence of device would be presented if the principal function of the 
coal mine (satisfying the requirements of the steel business) continued 
after the separation and the coal mine could be sold without adversely 
affecting the steel business. Similarly, in Example (10) of Sec. 1.355-
3(c), evidence of device would be presented if the principal function of 
the sales operation after the separation is to sell the output from the 
manufacturing operation and the sales operation could be sold without 
adversely affecting the manufacturing operation.
    (3) Nondevice factors--(i) In general. The presence of any of the 
nondevice factors specified in this subparagraph (3) is evidence of 
nondevice. The strength of this evidence depends on all of the facts and 
circumstances.
    (ii) Corporate business purpose. The corporate business purpose for 
the transaction is evidence of nondevice. The stronger the evidence of 
device (such as the presence of the device factors specified in 
paragraph (d)(2) of this section), the stronger the corporate business 
purpose required to prevent the determination that the transaction was 
used principally as a device. Evidence of device presented by the 
transfer or retention of assets not used in a trade or business that 
satisfies the requirements of section 355(b) can be outweighed by the 
existence of a corporate business purpose for those transfers or 
retentions. The assessment of the strength of a corporate business 
purpose will be based on all of the facts and circumstances, including, 
but not limited to, the following factors:
    (A) The importance of achieving the purpose to the success of the 
business;
    (B) The extent to which the transaction is prompted by a person not 
having a proprietary interest in either corporation, or by other outside 
factors beyond the control of the distributing corporation; and
    (C) The immediacy of the conditions prompting the transaction.
    (iii) Distributing corporation publicly traded and widely held. The 
fact that the distributing corporation is publicly traded and has no 
shareholder who is directly or indirectly the beneficial owner of more 
than five percent of any class of stock is evidence of nondevice.
    (iv) Distribution to domestic corporate shareholders. The fact that 
the stock of the controlled corporation is distributed to one or more 
domestic corporations that, if section 355 did not apply, would be 
entitled to a deduction under section 243(a)(1) available to 
corporations meeting the stock ownership requirements of section 243(c), 
or a deduction under section 243(a)(2) or (3) or 245(b) is evidence of 
nondevice.
    (4) Examples. The provisions of paragraph (d)(1) through (3) of this 
section may be illustrated by the following examples:


[[Page 203]]


    Example 1. Individual A owns all of the stock of corporation X, 
which is engaged in the warehousing business. X owns all of the stock of 
corporation Y, which is engaged in the transportation business. X 
employs individual B, who is extremely knowledgeable of the warehousing 
business in general and the operations of X in particular. B has 
informed A that he will seriously consider leaving the company if he is 
not given the opportunity to purchase a significant amount of stock of 
X. Because of his knowledge and experience, the loss of B would 
seriously damage the business of X. B cannot afford to purchase any 
significant amount of stock of X as long as X owns Y. Accordingly, X 
distributes the stock of Y to A and A subsequently sells a portion of 
his X stock to B. However, X could have issued additional shares to B 
sufficient to give B an equivalent ownership interest in X. There is no 
other evidence of device or evidence of nondevice. In light of the fact 
that X could have issued additional shares to B, the sale of X stock by 
A is substantial evidence of device. The transaction is considered to 
have been used principally as a device. See paragraph (d)(1), (2)(ii), 
(iii)(A), (B) and (D), and (3)(i) and (ii) of this section.
    Example 2. Corporation X owns and operates a fast food restaurant in 
State M and owns all of the stock of corporation Y, which owns and 
operates a fast food restaurant in State N. X and Y operate their 
businesses under franchises granted by D and E, respectively. X owns 
cash and marketable securities that exceed the reasonable needs of its 
business but whose value is small relative to the value of its business. 
E has recently changed its franchise policy and will no longer grant or 
renew franchises to subsidiaries (or other members of the same 
affiliated group) of corporations operating businesses under franchises 
granted by its competitors. Thus, Y will lose its franchise if it 
remains a subsidiary of X. The franchise is about to expire. 
Accordingly, X distributes the stock of Y pro rata among X's 
shareholders. X retains its business and transfers cash and marketable 
securities to Y in an amount proportional to the value of Y's business. 
There is no other evidence of device or evidence of nondevice. The 
transfer by X to Y and the retention by X of cash and marketable 
securities is relatively weak evidence of device because after the 
transfer X and Y hold cash and marketable securities in amounts 
proportional to the values of their businesses. The fact that the 
distribution is pro rata is evidence of device. A strong corporate 
business purpose is relatively strong evidence of nondevice. 
Accordingly, the transaction is considered not to have been used 
principally as a device. See paragraph (d)(1), (2)(ii), (iv)(A), and (B) 
and (3)(i) and (ii)(A), (B) and (C) of this section.
    Example 3. Corporation X is engaged in a regulated business in State 
M and owns all of the stock of corporation Y, which is not engaged in a 
regulated business in State M. State M has recently amended its laws to 
provide that affiliated corporations operating in M may not conduct both 
regulated and unregulated businesses. X transfers cash not related to 
the reasonable needs of the business of X or Y to Y and then distributes 
the stock of Y pro rata among X's shareholders. As a result of the 
transfer of cash, the ratio of the value of its assets not used in a 
trade or business that satisfies the requirements of section 355(b) to 
the value of its business is substantially greater for Y than for X. 
There is no other evidence of device or evidence of nondevice. The 
transfer of cash by X to Y is relatively strong evidence of device 
because after the transfer Y holds disproportionately many assets that 
are not used in a trade or business that satisfies the requirements of 
section 355(b). The fact that the distribution is pro rata is evidence 
of device. The strong business purpose is relatively strong evidence of 
nondevice, but it does not pertain to the transfer. Accordingly, the 
transaction is considered to have been used principally as a device. See 
paragraph (d)(1), (2)(ii), (iv)(A) and (B), and (3) and (i) and (ii) of 
this section.
    Example 4. The facts are the same as in Example (3), except that, 
instead of transferring cash to Y, X purchases operating assets 
unrelated to the business of Y and transfers them to Y prior to the 
distribution. There is no other evidence of device or evidence of 
nondevice. The transaction is considered to have been used principally 
as a device. See paragraph (d)(1), (2)(ii), (iv)(A) and (B), and (3)(i) 
and (ii) of this section.

    (5) Transactions ordinarily not considered as a device--(i) In 
general. This subparagraph (5) specifies three distributions that 
ordinarily do not present the potential for tax avoidance described in 
paragraph (d)(1) of this section. Accordingly, such distributions are 
ordinarily considered not to have been used principally as a device, 
notwithstanding the presence of any of the device factors described in 
paragraph (d)(2) of this section. A transaction described in paragraph 
(d)(5)(iii) or (iv) of this section is not protected by this 
subparagraph (5) from a determination that it was used principally as a 
device if it involves the distribution of the stock of more than one 
controlled corporation and facilitates the avoidance of the dividend 
provisions of the Code through the subsequent sale or exchange of stock 
of one corporation and the retention of the stock of another 
corporation.

[[Page 204]]

    (ii) Absence of earnings and profits. A distribution is ordinarily 
considered not to have been used principally as a device if--
    (A) The distributing and controlled corporations have no accumulated 
earnings and profits at the beginning of their respective taxable years,
    (B) The distributing and controlled corporations have no current 
earnings and profits as of the date of the distribution, and
    (C) No distribution of property by the distributing corporation 
immediately before the separation would require recognition of gain 
resulting in current earnings and profits for the taxable year of the 
distribution.
    (iii) Section 303(a) transactions. A distribution is ordinarily 
considered not to have been used principally as a device if, in the 
absence of section 355, with respect to each shareholder distributee, 
the distribution would be a redemption to which section 303(a) applied.
    (iv) Section 302(a) transactions. A distribution is ordinarily 
considered not to have been used principally as a device if, in the 
absence of section 355, with respect to each shareholder distributee, 
the distribution would be a redemption to which section 302(a) applied. 
For purposes of the preceding sentence, section 302(c)(2)(A)(ii) and 
(iii) shall not apply.
    (v) Examples. The provisions of this subparagraph (5) may be 
illustrated by the following examples:

    Example 1. The facts are the same as in Example (3) of paragraph 
(d)(4) of this section, except that X and Y had no accumulated earnings 
and profits at the beginning of its taxable year, X and Y have no 
current earnings and profits as of the date of the distribution, and no 
distribution of property by X immediately before the separation would 
require recognition of gain that would result in earnings and profits 
for the taxable year of the distribution. The transaction is considered 
not to have been used principally as a device. See paragraph (d)(5)(i) 
and (ii) of this section.
    Example 2. Corporation X is engaged in three businesses: a hotel 
business, a restaurant business, and a rental real estate business. 
Individuals A, B, and C own all of the stock of X. X transfers the 
restaurant business to new corporation Y and transfers the rental real 
estate business to new corporation Z. X then distributes the stock of Y 
and Z pro rata between B and C in exchange for all of their stock in X. 
In the absence of section 355, the distribution would be a redemption to 
which section 302(a) applied. Since this distribution involves the stock 
of more than one controlled corporation and facilitates the avoidance of 
the dividend provisions of the Code through the subsequent sale or 
exchange of stock in one corporation and the retention of the stock of 
another corporation, it is not protected by paragraph (d)(5)(i) and (iv) 
of this section from a determination that it was used principally as a 
device. Thus, the determination of whether the transaction was used 
principally as a device must be made from all the facts and 
circumstances, including the presence of the device factors and 
nondevice factors specified in paragraph (d)(2) and (3) of this section.

    (e) Stock and securities distributed--(1) In general. Section 355 
applies to a distribution only if the distributing corporation 
distributes--
    (i) All of the stock and securities of the controlled corporation 
that it owns, or
    (ii) At least an amount of the stock of the controlled corporation 
that constitutes control as defined in section 368(c). In such a case, 
all, or any part, of the securities of the controlled corporation may be 
distributed, and paragraph (e)(2) of this section shall apply.
    (2) Additional rules. Where a part of either the stock or the 
securities of the controlled corporation is retained under paragraph 
(e)(1)(ii) of this section, it must be established to the satisfaction 
of the Commissioner that the retention by the distributing corporation 
was not in pursuance of a plan having as one of its principal purposes 
the avoidance of Federal income tax. Ordinarily, the corporate business 
purpose or purposes for the distribution will require the distribution 
of all of the stock and securities of the controlled corporation. If the 
distribution of all of the stock and securities of a controlled 
corporation would be treated to any extent as a distribution of ``other 
property'' under section 356, this fact tends to establish that the 
retention of stock or securities is in pursuance of a plan having as one 
of its principal purposes the avoidance of Federal income tax.
    (f) Principal amount of securities--(1) Securities received. Section 
355 does not apply to a distribution if, with respect

[[Page 205]]

to any shareholder or security holder, the principal amount of 
securities received exceeds the principal amount of securities 
surrendered, or securities are received but no securities are 
surrendered. In such cases, see section 356.
    (2) Only stock received. If only stock is received in a distribution 
to which section 355(a)(1)(A) applies, the principal amount of the 
securities surrendered, if any, and the par value or stated value of the 
stock surrendered, if any, are not relevant to the application of that 
section.
    (g) [Reserved] For further guidance, see Sec. 1.355-2T(g).
    (h) Active conduct of a trade or business. Section 355 applies to a 
distribution only if the requirements of Sec. 1.355-3 (relating to the 
active conduct of a trade or business) are satisfied.
    (i) [Reserved] For further guidance, see Sec. 1.355-2T(i).

[T.D. 8238, 54 FR 290, Jan. 5, 1989; 54 FR 5577, Feb. 3, 1989; 57 FR 
28463, June 25, 1992; T.D. 9435, 73 FR 75950, Dec. 15, 2008]



Sec. 1.355-2T  Limitations (temporary).

    (a) through (f)(2) [Reserved] For further guidance, see Sec. 1.355-
2(a) through (f)(2).
    (g) Recently acquired controlled stock under section 355(a)(3)(B)--
(1) Other property. Except as provided in paragraph (g)(2) of this 
section, for purposes of section 355(a)(1)(A), section 355(c), and so 
much of section 356 as relates to section 355, stock of a controlled 
corporation acquired by the DSAG in a taxable transaction (as defined in 
paragraph (g)(4) of this section) within the five-year period ending on 
the date of the distribution (pre-distribution period) shall not be 
treated as stock of the controlled corporation but shall be treated as 
``other property.'' Transfers of controlled corporation stock that is 
owned by the DSAG immediately before and immediately after the transfer 
are disregarded and are not acquisitions for purposes of this paragraph 
(g)(1).
    (2) Exceptions. Paragraph (g)(1) of this section does not apply to 
an acquisition of stock of the controlled corporation--
    (i) If the controlled corporation is a DSAG member at any time after 
the acquisition (but prior to the distribution); or
    (ii) Described in Sec. 1.355-3(b)(4)(iii).
    (3) DSAG. For purposes of this paragraph (g), a DSAG is the 
distributing corporation's separate affiliated group (the affiliated 
group which would be determined under section 1504(a) if such 
corporation were the common parent and section 1504(b) did not apply) 
that consists of the distributing corporation as the common parent and 
all corporations affiliated with the distributing corporation through 
stock ownership described in section 1504(a)(1)(B) (regardless of 
whether the corporations are includible corporations under section 
1504(b)). For purposes of paragraph (g)(1) of this section, any 
reference to the DSAG is a reference to the distributing corporation if 
it is not the common parent of a separate affiliated group.
    (4) Taxable transaction--(i) Generally. For purposes of this 
paragraph (g), a taxable transaction is a transaction in which gain or 
loss was recognized in whole or in part.
    (ii) Dunn Trust and predecessor issues. [Reserved]
    (5) Examples. The following examples illustrate this paragraph (g). 
Assume that C, D, P, and S are corporations, X is an unrelated 
individual, each of the transactions is unrelated to any other 
transaction and, but for the issue of whether C stock is treated as 
``other property'' under section 355(a)(3)(B), the distributions satisfy 
all of the requirements of section 355. No inference should be drawn 
from any of these examples as to whether any requirements of section 355 
other than section 355(a)(3)(B), as specified, are satisfied. 
Furthermore, the following definitions apply:
    (i) Purchase is an acquisition that is a taxable transaction.
    (ii) Section 368(c) stock is stock constituting control within the 
meaning of section 368(c).
    (iii) Section 1504(a)(2) stock is stock meeting the requirements of 
section 1504(a)(2).

    Example 1. Hot stock. For more than five years, D has owned section 
368(c) stock but not section 1504(a)(2) stock of C. In year 6, D 
purchases additional C stock from X. However, D does not own section 
1504(a)(2) stock

[[Page 206]]

of C after the year 6 purchase. If D distributes all of its C stock 
within five years after the year 6 purchase, for purposes of section 
355(a)(1)(A), section 355(c), and so much of section 356 as relates to 
section 355, the C stock purchased in year 6 would be treated as ``other 
property.'' See paragraph (g)(1) of this section.
    Example 2. C becomes a DSAG member. For more than five years, D has 
owned section 368(c) stock but not section 1504(a)(2) stock of C. In 
year 6, D purchases additional C stock from X such that D's total 
ownership of C is section 1504(a)(2) stock. If D distributes all of its 
C stock within five years after the year 6 purchase, the distribution of 
the C stock purchased in year 6 would not be treated as ``other 
property'' because C becomes a DSAG member. See paragraph (g)(2)(i) of 
this section. The result would be the same if D did not own any C stock 
prior to year 6 and D purchased all of the C stock in year 6. See 
paragraph (g)(2)(i) of this section. Similarly, if D did not own any C 
stock prior to year 6, D purchased 20 percent of the C stock in year 6, 
and then acquired all of the remaining C stock in year 7, the C stock 
purchased in year 6 and the C stock acquired in year 7 (even if 
purchased) would not be treated as ``other property'' because C becomes 
a DSAG member. See paragraph (g)(2)(i) of this section.
    Example 3. Intra-SAG transaction. For more than five years, D has 
owned all of the stock of S. D and S, in the aggregate, have owned 
section 368(c) stock but not section 1504(a)(2) stock of C. Therefore, D 
and S are DSAG members, but C is not. In year 6, D purchases S's C 
stock. If D distributes all of its C stock within five years after the 
year 6 purchase, the distribution of the C stock purchased in year 6 
would not be treated as ``other property''. D's purchase of the C stock 
from S is disregarded for purposes of paragraph (g)(1) of this section 
because that C stock was owned by the DSAG immediately before and 
immediately after the purchase. See paragraph (g)(1) of this section.
    Example 4. Affiliate exception. For more than five years, P has 
owned 90 percent of the sole outstanding class of the stock of D and a 
portion of the stock of C, and X has owned the remaining 10 percent of 
the D stock. Throughout this period, D has owned section 368(c) stock 
but not section 1504(a)(2) stock of C. In year 6, D purchases P's C 
stock. However, D does not own section 1504(a)(2) stock of C after the 
year 6 purchase. If D distributes all of its C stock to X in exchange 
for X's D stock within five years after the year 6 purchase, the 
distribution of the C stock purchased in year 6 would not be treated as 
``other property'' because the C stock was purchased from a member (P) 
of the affiliated group (as defined in Sec. 1.355-3(b)(4)(iv)) of which 
D is a member, and P did not purchase that C stock within the pre-
distribution period. See paragraph (g)(2)(ii) of this section.

    (h) [Reserved] For further guidance, see Sec. 1.355-2(h).
    (i) Effective/applicability date--(1) In general. Paragraphs (g)(1) 
through (g)(5) of this section apply to distributions occurring after 
December 15, 2008. However, except as provided in paragraph (i)(2) of 
this section, paragraphs (g)(1) through (g)(5) of this section do not 
apply to any distribution occurring after December 15, 2008, that is 
pursuant to a transaction which is--
    (i) Made pursuant to an agreement which was binding on December 15, 
2008, and at all times thereafter;
    (ii) Described in a ruling request submitted to the Internal Revenue 
Service on or before such date; or
    (iii) Described on or before such date in a public announcement or 
in a filing with the Securities and Exchange Commission.
    (2) Transition election. In the case of any distribution described 
in the second sentence of paragraph (i)(1) of this section, taxpayers 
may elect to apply all of paragraphs (g)(1) through (g)(5) of this 
section. However, neither the distributing corporation nor any person 
related to the distributing corporation within the meaning of section 
267(b) (determined immediately before or immediately after the 
distribution) may make such an election with respect to a distribution 
unless all such persons make such an election with respect to such 
distribution.
    (3) Retroactive election. In the case of any distribution occurring 
on or before December 15, 2008, taxpayers may elect to apply all of 
paragraphs (g)(1) through (g)(5) of this section to distributions to 
which section 4(b) of the Tax Technical Corrections Act of 2007, Public 
Law 110-172 (121 Stat. 2473, 2476) applies (generally applicable to 
distributions made after May 17, 2006, as provided in section 4(d) of 
that act). However, neither the distributing corporation nor any person 
related to the distributing corporation within the meaning of section 
267(b) (determined immediately before or immediately after the 
distribution) may make such an election with respect to a distribution 
unless all such persons make such

[[Page 207]]

an election with respect to such distribution.
    (4) Manner of election. Taxpayers may make any election available 
under this paragraph (i) by applying the selected rule on its original 
or amended return.
    (5) Prior law. For distributions to which paragraphs (g)(1) through 
(g)(5) of this section do not apply, see Sec. 1.355-2(g), as contained 
in 26 CFR part 1, revised as of April 1, 2008.
    (6) Expiration date. The applicability of paragraph (i) of this 
section will expire on December 15, 2011.

[T.D. 9435, 73 FR 75950, Dec. 15, 2008; 74 FR 3420, Jan. 21, 2009]



Sec. 1.355-3  Active conduct of a trade or business.

    (a) General requirements--(1) Application of section 355. Under 
section 355(b)(1), a distribution of stock, or stock and securities, of 
a controlled corporation qualifies under section 355 only if--
    (i) The distributing and the controlled corporations are each 
engaged in the active conduct of a trade or business immediately after 
the distribution (section 355(b)(1)(A)), or
    (ii) Immediately before the distribution, the distributing 
corporation had no assets other than stock or securities of the 
controlled corporations, and each of the controlled corporations is 
engaged in the active conduct of a trade or business immediately after 
the distribution (section 355(b)(1)(B)). A de minimis amount of assets 
held by the distributing corporation shall be disregarded for purposes 
of this paragraph (a)(1)(ii).
    (2) Examples. Paragraph (a)(1) of this section may be illustrated by 
the following examples:

    Example 1. Prior to the distribution, corporation X is engaged in 
the active conduct of a trade or business and owns all of the stock of 
corporation Y, which also is engaged in the active conduct of a trade or 
business. X distributes all of the stock of Y to X's shareholders, and 
each corporation continues the active conduct of its trade or business. 
The active business requirement of section 355(b)(1)(A) is satisfied.
    Example 2. The facts are the same as in Example (1), except that X 
transfers all of its assets other than the stock of Y to a new 
corporation in exchange for all of the stock of the new corporation and 
then distributes the stock of both controlled corporations to X's 
shareholders. The active business requirement of section 355(b)(1)(B) is 
satisfied.

    (b) Active conduct of a trade or business defined--(1) In general. 
Section 355(b)(2) provides rules for determining whether a corporation 
is treated as engaged in the active conduct of a trade or business for 
purposes of section 355(b)(1). Under section 355(b)(2)(A), a corporation 
is treated as engaged in the active conduct of a trade or business if it 
is itself engaged in the active conduct of a trade or business or if 
substantially all of its assets consist of the stock, or stock and 
securities, of a corporation or corporations controlled by it 
(immediately after the distribution) each of which is engaged in the 
active conduct of a trade or business.
    (2) Active conduct of a trade or business immediately after 
distribution--(i) In general. For purposes of section 355(b), a 
corporation shall be treated as engaged in the ``active conduct of a 
trade or business'' immediately after the distribution if the assets and 
activities of the corporation satisfy the requirements and limitations 
described in paragraph (b)(2)(ii), (iii), and (iv) of this section.
    (ii) Trade or business. A corporation shall be treated as engaged in 
a trade or business immediately after the distribution if a specific 
group of activities are being carried on by the corporation for the 
purpose of earning income or profit, and the activities included in such 
group include every operation that forms a part of, or a step in, the 
process of earning income or profit. Such group of activities ordinarily 
must include the collection of income and the payment of expenses.
    (iii) Active conduct. For purposes of section 355(b), the 
determination whether a trade or business is actively conducted will be 
made from all of the facts and circumstances. Generally, the corporation 
is required itself to perform active and substantial management and 
operational functions. Generally, activities performed by the 
corporation itself do not include activities performed by persons 
outside the corporation, including independent contractors. A 
corporation may satisfy the requirements of this subdivision (iii) 
through the activities that it performs

[[Page 208]]

itself, even though some of its activities are performed by others. 
Separations of real property all or substantially all of which is 
occupied prior to the distribution by the distributing or the controlled 
corporation (or by any corporation controlled directly or indirectly by 
either of those corporations) will be carefully scrutinized with respect 
to the requirements of section 355(b) and this Sec. 1.355-3.
    (iv) Limitations. The active conduct of a trade or business does not 
include--
    (A) The holding for investment purposes of stock, securities, land, 
or other property, or
    (B) The ownership and operation (including leasing) of real or 
personal property used in a trade or business, unless the owner performs 
significant services with respect to the operation and management of the 
property.
    (3) Active conduct for five-year period preceding distribution. 
Under section 355(b)(2)(B), a trade or business that is relied upon to 
meet the requirements of section 355(b) must have been actively 
conducted throughout the five-year period ending on the date of the 
distribution. For purposes of this subparagraph (3)--
    (i) Activities which constitute a trade or business under the tests 
described in paragraph (b)(2) of this section shall be treated as 
meeting the requirement of the preceding sentence if such activities 
were actively conducted throughout the 5-year period ending on the date 
of distribution, and
    (ii) The fact that a trade or business underwent change during the 
five-year period preceding the distribution (for example, by the 
addition of new or the dropping of old products, changes in production 
capacity, and the like) shall be disregarded, provided that the changes 
are not of such a character as to constitute the acquisition of a new or 
different business. In particular, if a corporation engaged in the 
active conduct of one trade or business during that five-year period 
purchased, created, or otherwise acquired another trade or business in 
the same line of business, then the acquisition of that other business 
is ordinarily treated as an expansion of the original business, all of 
which is treated as having been actively conducted during that five-year 
period, unless that purchase, creation, or other acquisition effects a 
change of such a character as to constitute the acquisition of a new or 
different business.
    (4) Special rules for acquisition of a trade or business (Prior to 
the Revenue Act of 1987 and Technical and Miscellaneous Revenue Act of 
1988)--(i) In general. Under section 355(b)(2)(C), a trade or business 
relied upon to meet the requirements of section 355(b) must not have 
been acquired by the distributing corporation, the controlled 
corporation, or another member of the affiliated group during the five-
year period ending on the date of the distribution unless it was 
acquired in a transaction in which no gain or loss was recognized. 
Similarly, under section 355(b)(2)(D), the trade or business must not 
have been indirectly acquired by any of those corporations (or a 
predecessor in interest of any of those corporations) during that five-
year period in a transaction in which gain or loss was recognized in 
whole or in part and which consisted of the acquisition of control of 
the corporation directly engaged in the trade or business, or the 
indirect acquisition of control of that corporation through the direct 
or indirect acquisition of control of one or more other corporations. A 
trade or business acquired, directly or indirectly, within the five-year 
period ending on the date of the distribution in a transaction in which 
the basis of the assets acquired was not determined in whole or in part 
by reference to the transferor's basis does not qualify under section 
355(b)(2), even though no gain or loss was recognized by the 
transferror.
    (ii) Example. Paragraph (b)(4)(i) of this section may be illustrated 
by the following example:

    Example. In 1985, corporation X, which operates a business and has 
cash and other liquid assets, purchases all of the stock of corporation 
Y, which is engaged in the active conduct of a trade or business. Later 
in the same year, X merges into Y in a ``downstream'' statutory merger. 
In 1986, Y transfers the business assets formerly owned by X to a new 
subsidiary, corporation Z, and then distributes the stock of Z to Y's 
shareholders. Section 355 does not apply to the distribution of the 
stock of Z because the

[[Page 209]]

trade or business of Y was indirectly acquired by X, a predecessor in 
interest of Y, during the five-year period preceding the distribution.

    (iii) Gain or loss recognized in certain transactions. The 
requirements of section 355(b)(2)(C) and (D) are intended to prevent the 
direct or indirect acquisition of a trade or business by a corporation 
in anticipation of a distribution by the corporation of that trade of 
business in a distribution to which section 355 would otherwise apply. A 
direct or indirect acquisition of a trade or business by one member of 
an affiliated group from another member of the group is not the type of 
transaction to which section 355(b)(2)(C) and (D) is intended to apply. 
Therefore, in applying section 355(b)(2)(C) or (D), such an acquisition, 
even though taxable, shall be disregarded.
    (iv) Affiliated group. For purposes of this subparagraph (4), the 
term affiliated group means an affiliated group as defined in section 
1504(a) (without regard to section 1504(b)), except that the term stock 
includes nonvoting stock described in section 1504(a)(4).
    (5) Special rules for acquisition of a trade or business (After the 
Revenue Act of 1987 and Technical and Miscellaneous Revenue Act of 
1988). [Reserved]
    (c) Examples. The following examples illustrate section 355(b)(2)(A) 
and (B) and paragraph (b)(1), (2), and (3) of this section. However, a 
transaction that satisfies these active business requirements will 
qualify under section 355 only if it satisfies the other requirements of 
section 355 (a) and (b).

    Example 1. Corporation X is engaged in the manufacture and sale of 
soap and detergents and also owns investment securities. X transfers the 
investment securities to new subsidiary Y and distributes the stocks of 
Y to X's shareholders. Y does not satisfy the requirements of section 
355(b) because the holding of investment securities does not constitute 
the active conduct of a trade or business. See paragraph (b)(2)(iv)(A) 
of this section.
    Example 2. Corporation X owns, manages, and derives rental income 
from an office building and also owns vacant land. X transfers the land 
to new subsidiary Y and distributes the stock of Y to X's shareholders. 
Y will subdivide the land, install streets and utilities, and sell the 
developed lots to various homebuilders. Y does not satisfy the 
requirements of section 355(b) because no significant development 
activities were conducted with respect to the land during the five-year 
period ending on the date of the distribution. See paragraph (b)(3) of 
this section.
    Example 3. Corporation X owns land on which it conducts a ranching 
business. Oil has been discovered in the area, and it is apparent that 
oil may be found under the land on which the ranching business is 
conducted. X has engaged in no significant activities in connection with 
its mineral rights. X transfers its mineral rights to new subsidiary Y 
and distributes the stock of Y to X's shareholders. Y will actively 
pursue the development of the oil producing potential of the property. Y 
does not satisfy the requirements of section 355(b) because X engaged in 
no significant exploitation activities with respect to the mineral 
rights during the five-year period ending on the date of the 
distribution. See paragraph (b)(3) of this section.
    Example 4. For more than five years, corporation X has conducted a 
single business of constructing sewage disposal plants and other 
facilities. X transfers one-half of its assets to new subsidiary Y. 
These assets include a contract for the construction of a sewage 
disposal plant in State M, construction equipment, cash, and other 
tangible assets. X retains a contract for the construction of a sewage 
disposal plant in State N, construction equipment, cash, and other 
intangible assets. X then distributes the stock of Y to one of X's 
shareholders in exchange for all of his stock of X. X and Y both satisfy 
the requirements of section 355(b). See paragraph (b)(3)(i) of this 
section.
    Example 5. For the past six years, corporation X has owned and 
operated two factories devoted to the production of edible pork skins. 
The entire output of one factory is sold to one customer, C, while the 
output of the second factory is sold to C and a number of other 
customers. To eliminate errors in packaging, X opens a new factory. 
Thereafter, orders from C are processed and packaged at the two original 
factories, while the new factory handles only orders from other 
customers. Eight months after opening the new factory, X transfers it 
and related business assets to new subsidiary Y and distributes the 
stock of Y to X's shareholders. X and Y both satisfy the requirements of 
section 355(b). See paragraph (b)(3)(i) and (ii) of this section.
    Example 6. Corporation X has owned and operated a men's retail 
clothing store in the downtown area of the City of G for nine years and 
has owned and operated another men's retail clothing store in a suburban 
area of G for seven years. X transfers the store building, fixtures, 
inventory, and other assets related to the operations of the suburban 
store to new subsidiary Y. X also transfers to Y the delivery trucks and 
delivery

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personnel that formerly served both stores. Henceforth, X will contract 
with a local public delivery service to make its deliveries. X retains 
the warehouses that formerly served both stores. Henceforth, Y will 
lease warehouse space from an unrelated public warehouse company. X then 
distributes the stock of Y to X's shareholders. X and Y both satisfy the 
requirements of section 355(b). See paragraph (b)(3)(i) of this section.
    Example 7. For the past nine years, corporation X has owned and 
operated a department store in the downtown area of the City of G. Three 
years ago, X acquired a parcel of land in a suburban area of G and 
constructed a new department store on it. X transfers the suburban store 
and related business assets to new subsidiary Y and distributes the 
stock of Y to X's shareholders. After the distribution, each store has 
its own manager and is operated independently of the other store. X and 
Y both satisfy the requirements of section 355(b). See paragraph 
(b)(3)(i) and (ii) of this section.
    Example 8. For the past six years, corporation X has owned and 
operated hardware stores in several states. Two years ago, X purchased 
all of the assets of a hardware store in State M, where X had not 
previously conducted business. X transfers the State M store and related 
business assets to new subsidiary Y and distributes the stock of Y to 
X's shareholders. After the distribution, the State M store has its own 
manager and is operated independently of the other stores. X and Y both 
satisfy the requirements of section 355(b). See paragraph (b)(3)(i) and 
(ii) of this section.
    Example 9. For the past eight years, corporation X has engaged in 
the manufacture and sale of household products. Throughout this period, 
X has maintained a research department for use in connection with its 
manufacturing activities. The research department has 30 employees 
actively engaged in the development of new products. X transfers the 
research department to new subsidiary Y and distributes the stock of Y 
to X's shareholders. After the distribution, Y continues its research 
operations on a contractual basis with several corporations, including 
X. X and Y both satisfy the requirements of section 355(b). See 
paragraph (b)(3)(i) of this section. The result in this example is the 
same if, after the distribution, Y continues its research operations but 
furnishes its services only to X. See paragraph (b)(3)(i) of this 
section. However, see Sec. 1.355-2 (d)(2)(iv)(C) (related function 
device factor) for possible evidence of device.
    Example 10. For the past six years, corporation X has processed and 
sold meat products. X derives income from no other source. X separates 
the sales function from the processing function by transferring the 
business assets related to the sales function and cash for working 
capital to new subsidiary Y. X then distributes the stock of Y to X's 
shareholders. After the distribution, Y purchases for resale the meat 
products processed by X. X and Y both satisfy the requirements of 
section 355(b). See paragraph (b)(3)(i) of this section. However, see 
Sec. 1.355-2(d)(2)(iv)(C) (related function device factor) for possible 
evidence of device.
    Example 11. For the past eight years, corporation X has been engaged 
in the manufacture and sale of steel and steel products. X owns all of 
the stock of corporation Y, which, for the past six years, has owned and 
operated a coal mine for the sole purpose of supplying X's coal 
requirements in the manufacture of steel. X distributes the stock of Y 
to X's shareholders. X and Y both satisfy the requirements of section 
355 (b). See paragraph (b)(3)(i) of this section. However, see Sec. 
1.355-2 (d)(2)(iv)(C) (related function device factor) for possible 
evidence of device.
    Example 12. For the past seven years, corporation X, a bank, has 
owned an eleven-story office building, the ground floor of which X has 
occupied in the conduct of its banking business. The remaining ten 
floors are rented to various tenants. Throughout this seven-year period, 
the building has been managed and maintained by employees of the bank. X 
transfers the building to new subsidiary Y and distributes the stock of 
Y to X's shareholders. Henceforth, Y will manage the building, negotiate 
leases, seek new tenants, and repair and maintain the building. X and Y 
both satisfy the requirements of section 355 (b). See paragraph (b)(3) 
of this section.
    Example 13. For the past nine years, corporation X, a bank, has 
owned a two-story building, the ground floor and one half of the second 
floor of which X has occupied in the conduct of its banking business. 
The other half of the second floor has been rented as storage space to a 
neighboring retail merchant. X transfers the building to new subsidiary 
Y and distributes the stock of Y to X's shareholders. After the 
distribution, X leases from Y the space in the building that it formerly 
occupied. Under the lease, X will repair and maintain its portion of the 
building and pay property taxes and insurance. Y does not satisfy the 
requirements of section 355 (b) because it is not engaged in the active 
conduct of a trade or business immediately after the distribution. See 
paragraph (b)(2)(iv)(A) of this section. This example does not address 
the question of whether the activities of X with respect to the building 
prior to the separation would constitute the active conduct of a trade 
or business.

[T.D. 8238, 54 FR 294, Jan. 5, 1989]



Sec. 1.355-4  Non pro rata distributions, etc.

    Section 355 provides for nonrecognition of gain or loss with respect 
to a

[[Page 211]]

distribution whether or not (a) the distribution is pro rata with 
respect to all of the shareholders of the distributing corporation, (b) 
the distribution is pursuant to a plan of reorganization within the 
meaning of section 368 (a) (1)(D), or (c) the shareholder surrenders 
stock in the distributing corporation. Under section 355, the stock of a 
controlled corporation may consist of common stock or preferred stock. 
(See, however, section 306 and the regulations thereunder.) Section 355 
does not apply, however, if the substance of a transaction is merely an 
exchange between shareholders or security holders of stock or securities 
in one corporation for stock or securities in another corporation. For 
example, if two individuals, A and B, each own directly 50 percent of 
the stock of corporation X and 50 percent of the stock of corporation Y, 
section 355 would not apply to a transaction in which A and B transfer 
all of their stock of X and Y to a new corporation Z, for all of the 
stock of Z, and Z then distributes the stock of X to A and the stock of 
Y to B.

[T.D. 8238, 54 FR 296, Jan. 5, 1989]



Sec. 1.355-5  Records to be kept and information to be filed.

    (a) Distributing corporation--(1) In general. Every corporation that 
makes a distribution (the distributing corporation) of stock or 
securities of a controlled corporation, as described in section 355 (or 
so much of section 356 as relates to section 355), must include a 
statement entitled, ``STATEMENT PURSUANT TO Sec. 1.355-5(a) BY [INSERT 
NAME AND EMPLOYER IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A 
DISTRIBUTING CORPORATION,'' on or with its return for the year of the 
distribution. If the distributing corporation is a controlled foreign 
corporation (within the meaning of section 957), each United States 
shareholder (within the meaning of section 951(b)) with respect thereto 
must include this statement on or with its return. The statement must 
include--
    (i) The name and employer identification number (if any) of the 
controlled corporation;
    (ii) The name and taxpayer identification number (if any) of every 
significant distributee;
    (iii) The date of the distribution of the stock or securities of the 
controlled corporation;
    (iv) The aggregate fair market value and basis, determined 
immediately before the distribution or exchange, of the stock, 
securities, or other property (including money) distributed by the 
distributing corporation in the transaction; and
    (v) The date and control number of any private letter ruling(s) 
issued by the Internal Revenue Service in connection with the 
transaction.
    (2) Special rule when an asset transfer precedes a stock 
distribution. If the distributing corporation transferred property to 
the controlled corporation in a transaction described in section 351 or 
368, as part of a plan to then distribute the stock or securities of the 
controlled corporation in a transaction described in section 355 (or so 
much of section 356 as relates to section 355), then, unless paragraph 
(a)(1)(v) of this section applies, the distributing corporation must 
also include on or with its return for the year of the distribution the 
statement required by Sec. 1.351-3(a) or 1.368-3(a). If the 
distributing corporation is a controlled foreign corporation (within the 
meaning of section 957), each United States shareholder (within the 
meaning of section 951(b)) with respect thereto must include the 
statement required by Sec. 1.351-3(a) or 1.368-3(a) on or with its 
return.
    (b) Significant distributee. Every significant distributee must 
include a statement entitled, ``STATEMENT PURSUANT TO Sec. 1.355-5(b) 
BY [INSERT NAME AND TAXPAYER IDENTIFICATION NUMBER (IF ANY) OF 
TAXPAYER], A SIGNIFICANT DISTRIBUTEE,'' on or with such distributee's 
return for the year in which such distribution is received. If a 
significant distributee is a controlled foreign corporation (within the 
meaning of section 957), each United States shareholder (within the 
meaning of section 951(b)) with respect thereto must include this 
statement on or with its return. The statement must include--
    (1) The names and employer identification numbers (if any) of the 
distributing and controlled corporations;

[[Page 212]]

    (2) The date of the distribution of the stock or securities of the 
controlled corporation; and
    (3) The aggregate basis, determined immediately before the exchange, 
of any stock or securities transferred by the significant distributee in 
the exchange, and the aggregate fair market value, determined 
immediately before the distribution or exchange, of the stock, 
securities or other property (including money) received by the 
significant distributee in the distribution or exchange.
    (c) Definitions. For purposes of this section:
    (1) Significant distributee means--
    (i) A holder of stock of a distributing corporation that receives, 
in a transaction described in section 355 (or so much of section 356 as 
relates to section 355), stock of a corporation controlled by the 
distributing corporation if, immediately before the distribution or 
exchange, such holder--
    (A) Owned at least five percent (by vote or value) of the total 
outstanding stock of the distributing corporation if the stock owned by 
such holder is publicly traded; or
    (B) Owned at least one percent (by vote or value) of the stock of 
the distributing corporation if the stock owned by such holder is not 
publicly traded; or
    (ii) A holder of securities of a distributing corporation that 
receives, in a transaction described in section 355 (or so much of 
section 356 as relates to section 355), stock or securities of a 
corporation controlled by the distributing corporation if, immediately 
before the distribution or exchange, such holder owned securities in 
such distributing corporation with a basis of $1,000,000 or more.
    (2) Publicly traded stock means stock that is listed on--
    (i) A national securities exchange registered under section 6 of the 
Securities Exchange Act of 1934 (15 U.S.C. 78f); or
    (ii) An interdealer quotation system sponsored by a national 
securities association registered under section 15A of the Securities 
Exchange Act of 1934 (15 U.S.C. 78o-3).
    (d) Substantiation information. Under Sec. 1.6001-1(e), taxpayers 
are required to retain their permanent records and make such records 
available to any authorized Internal Revenue Service officers and 
employees. In connection with the distribution or exchange described in 
this section, these records should specifically include information 
regarding the amount, basis, and fair market value of all property 
distributed or exchanged, and relevant facts regarding any liabilities 
assumed or extinguished as part of such distribution or exchange.
    (e) Effective/applicability date. This section applies to any 
taxable year beginning on or after May 30, 2006. However, taxpayers may 
apply this section to any original Federal income tax return (including 
any amended return filed on or before the due date (including 
extensions) of such original return) timely filed on or after May 30, 
2006. For taxable years beginning before May 30, 2006, see Sec. 1.355-5 
as contained in 26 CFR part 1 in effect on April 1, 2006.

[T.D. 9329, 72 FR 32799, June 14, 2007]



Sec. 1.355-6  Recognition of gain on certain distributions of stock or 

securities in controlled corporation.

    (a) Conventions--(1) Examples. For purposes of the examples in this 
section, unless otherwise stated, assume that P, S, T, X, Y, N, HC, D, 
D1, D2, D3, and C are corporations, A and B are individuals, 
shareholders are not treated as one person under section 355(d)(7), 
stock has been owned for more than five years and section 355(d)(6) and 
paragraph (e)(4) of this section do not apply, no election under section 
338 (if available) is made, and all transactions described are respected 
under general tax principles, including the step transaction doctrine. 
No inference should be drawn from any example as to whether any 
requirements of section 355 other than those of section 355(d), as 
specified, are satisfied.
    (2) Five-year period. For purposes of this section, the term five-
year period means the five-year period (determined after applying 
section 355(d)(6) and paragraph (e)(4) of this section) ending on the 
date of the distribution, but in no event beginning earlier than October 
10, 1990.

[[Page 213]]

    (3) Distributing securities. For purposes of determining if stock of 
any controlled corporation received in the distribution is disqualified 
stock described in section 355(d)(3)(B)(ii)(II) (relating to a 
distribution of controlled corporation stock on any securities in the 
distributing corporation acquired by purchase during the five-year 
period), references in this section to stock of a corporation that is or 
becomes a distributing corporation includes securities of the 
corporation. Similarly, a reference to stock in paragraph (c)(4) of this 
section (relating to a plan or arrangement) includes securities.
    (4) Marketable securities. Unless otherwise stated, any reference in 
this section to marketable stock includes marketable securities.
    (b) General rules and purposes of section 355(d)--(1) Disqualified 
distributions in general. In the case of a disqualified distribution, 
any stock or securities in the controlled corporation shall not be 
treated as qualified property for purposes of section 355(c)(2) or 
361(c)(2). In general, a disqualified distribution is any distribution 
to which section 355 (or so much of section 356 as relates thereto) 
applies if, immediately after the distribution--
    (i) Any person holds disqualified stock in the distributing 
corporation that constitutes a 50 percent or greater interest in such 
corporation; or
    (ii) Any person holds disqualified stock in the controlled 
corporation (or, if stock of more than one controlled corporation is 
distributed, in any controlled corporation) that constitutes a 50 
percent or greater interest in such corporation.
    (2) Disqualified stock--(i) In general. Disqualified stock is--
    (A) Any stock in the distributing corporation acquired by purchase 
during the five-year period; and
    (B) Any stock in any controlled corporation--
    (1) Acquired by purchase during the five-year period; or
    (2) Received in the distribution to the extent attributable to 
distributions on any stock in the distributing corporation acquired by 
purchase during the five-year period.
    (ii) Purchase. For the definition of a purchase for purposes of 
section 355(d) and this section, see section 355(d)(5) and paragraph (d) 
of this section.
    (iii) Exceptions--(A) Purchase eliminated. Stock (or an interest in 
another entity) that is acquired by purchase (including stock (or 
another interest) that is treated as acquired by purchase under 
paragraph (e)(2), (3), or (4) of this section) ceases to be acquired by 
that purchase if (and when) the basis resulting from the purchase is 
eliminated. For purposes of this paragraph (b)(2)(iii), basis resulting 
from the purchase is basis in the stock (or in an interest in another 
entity) that is directly purchased during the five-year period or that 
is treated as acquired by purchase during such period under paragraph 
(e)(2), (3), or (4) of this section.
    (B) Deemed purchase eliminated. Stock (or an interest in another 
entity) that is deemed purchased under section 355(d)(8) or paragraph 
(e)(1) of this section shall cease to be treated as purchased if (and 
when) the basis resulting from the purchase that effects the deemed 
purchase is eliminated.
    (C) Elimination of basis--(1) General rule. Basis in the stock of a 
corporation (or in an interest in another entity) is eliminated if (and 
when) it would no longer be taken into account by any person in 
determining gain or loss on a sale or exchange of any stock of such 
corporation (or an interest in the other entity). Basis is not 
eliminated, however, if it is allocated between stock of two 
corporations under Sec. 1.358-2(a).
    (2) Special rule for transferred and exchanged basis property. Basis 
of stock (or an interest in another entity) resulting from a purchase 
(the first purchase) is eliminated if (and when) such stock (or other 
interest) is subsequently transferred to another person in an exchange 
or other transfer to which paragraph (e)(2) or (3) of this section 
applies (the second purchase). The elimination of basis in stock (or in 
another interest) resulting from the first purchase, however, does not 
eliminate the basis resulting from the second purchase in the stock (or 
other interest) that is treated as acquired by purchase by the acquirer 
in a transaction

[[Page 214]]

to which paragraph (e)(2) of this section applies or by the person 
making the exchange in a transaction to which paragraph (e)(3) of this 
section applies.
    (3) Special rule for Split-offs and Split-ups. Under section 
355(d)(3)(B)(ii) and paragraph (b)(2)(i)(B)(2) of this section, 
disqualified stock includes controlled corporation stock received in 
exchange for distributing corporation stock acquired by purchase. Solely 
for purposes of determining whether controlled corporation stock 
received in a distribution in exchange for distributing corporation 
stock is disqualified stock described in that section and paragraph 
immediately after the distribution, paragraph (b)(2)(iii)(C)(2) of this 
section does not apply to the exchange to eliminate basis resulting from 
a purchase of that distributing corporation stock (notwithstanding that 
paragraph (e)(3) of this section applies to the exchange).
    (D) Special rule if basis allocated between two corporations. If the 
shareholder of a distributing corporation, pursuant to Sec. 1.358-2, 
allocates basis resulting from a purchase between the stock of two or 
more corporations then, following such allocation, the determination of 
whether such basis has been eliminated shall be made separately with 
respect to the stock of each such corporation.
    (3) Certain distributions not disqualified distributions because 
purposes of section 355(d) not violated--(i) In general. Notwithstanding 
the provisions of section 355(d)(2) and this paragraph (b), a 
distribution is not a disqualified distribution if the distribution does 
not violate the purposes of section 355(d) as provided in this paragraph 
(b)(3). A distribution does not violate the purposes of section 355(d) 
if the effect of the distribution is neither--
    (A) To increase ownership (combined direct and indirect) in the 
distributing corporation or any controlled corporation by a disqualified 
person; nor
    (B) To provide a disqualified person with a purchased basis in the 
stock of any controlled corporation.
    (ii) Disqualified person. A disqualified person is any person 
(taking into account section 355(d)(7) and paragraph (c)(4) of this 
section) that, immediately after a distribution, holds (directly or 
indirectly under section 355(d)(8) and paragraph (e)(1) of this section) 
disqualified stock in the distributing corporation or controlled 
corporation that--
    (A) The person--
    (1) Acquired by purchase under section 355(d)(5) or (8) and 
paragraphs (d) and (e) of this section during the five-year period, or
    (2) Received in the distribution to the extent attributable to 
distributions on any stock in the distributing corporation acquired by 
purchase under section 355(d)(5) or (8) and paragraphs (d) and (e) of 
this section by that person during the five-year period; and
    (B) Constitutes a 50 percent or greater interest in such corporation 
(under section 355(d)(4) and paragraph (c) of this section).
    (iii) Purchased basis. In general, a purchased basis is basis in 
controlled corporation stock that is disqualified stock. However, basis 
in controlled corporation stock that is disqualified stock will not be 
treated as purchased basis if the controlled corporation stock and any 
distributing corporation stock with respect to which the controlled 
corporation stock is distributed are treated as acquired by purchase 
solely under the attribution rules of section 355(d)(8) and paragraph 
(e)(1) of this section. The prior sentence will not apply, however, if 
the distributing corporation stock is treated as acquired by purchase 
under the attribution rules as a result of the acquisition of an 
interest in a partnership (the purchased partnership), and following the 
distribution, the controlled corporation stock is directly held by the 
purchased partnership (or a chain of partnerships that includes the 
purchased partnership).
    (iv) Increase in interest because of payment of cash in lieu of 
fractional shares. Any increase in direct or indirect ownership in the 
distributing corporation or any controlled corporation by a disqualified 
person because of a payment of cash in lieu of issuing fractional shares 
will be disregarded for purposes of paragraph (b)(3)(i)(A) of this 
section if the payment of the cash is solely to avoid the expense and 
inconvenience of issuing fractional share interests, and

[[Page 215]]

does not represent separately bargained for consideration.
    (v) Other exceptions. The Commissioner may provide by guidance 
published in the Internal Revenue Bulletin that other distributions are 
not disqualified distributions because they do not violate the purposes 
of section 355(d).
    (vi) Examples. The following examples illustrate this paragraph 
(b)(3):

    Example 1. Stock distributed in spin-off; no purchased basis. D owns 
all of the stock of D1, and D1 owns all the stock of C. A purchases 60 
percent of the D stock for cash. Within five years of A's purchase, D1 
distributes the C stock to D. A is treated as having purchased 60 
percent of the stock of both D1 and C on the date A purchases 60 percent 
of the D stock under the attribution rules of section 355(d)(8) and 
paragraph (e)(1) of this section. The C stock received by D is 
attributable to a distribution on purchased D1 stock under section 
355(d)(3)(B)(ii). Accordingly, the D1 and C stock each is disqualified 
stock under section 355(d)(3) and paragraph (b)(2) of this section, and 
A is a disqualified person under paragraph (b)(3)(ii) of this section. 
However, the purposes of section 355(d) under paragraph (b)(3)(i) of 
this section are not violated. A did not increase direct or indirect 
ownership in D1 or C. In addition, D's basis in the C stock is not a 
purchased basis under paragraph (b)(3)(iii) of this section because both 
the D1 and the C stock are treated as acquired by purchase solely under 
the attribution rules of section 355(d)(8) and paragraph (e)(1) of this 
section. Accordingly, D1's distribution of the C stock to D is not a 
disqualified distribution under section 355(d)(2) and paragraph (b)(1) 
of this section.
    Example 2. Stock distributed in spin-off; purchased basis. The facts 
are the same as Example 1, except that D immediately further distributes 
the C stock to its shareholders (including A) pro rata. The D and C 
stock each is disqualified stock under section 355(d)(3) and paragraph 
(b)(2) of this section, and A is a disqualified person under paragraph 
(b)(3)(ii) of this section. The purposes of section 355(d) under 
paragraph (b)(3)(i) of this section are violated. A did not increase 
direct or indirect ownership in D or C. However, A's basis in the C 
stock is a purchased basis under paragraph (b)(3)(iii) of this section 
because the D stock is not treated as acquired by purchase solely under 
the attribution rules of section 355(d)(8) and paragraph (e)(1) of this 
section. Accordingly, the further distribution is a disqualified 
distribution under section 355(d)(2) and paragraph (b)(1) of this 
section.
    Example 3. Stock distributed in split-off with ownership increase; 
purchased basis. The facts are the same as Example 1, except that D 
immediately further distributes the C stock to A in exchange for A's 
purchased stock in D. The C stock received by A is attributable to a 
distribution on purchased D stock under section 355(d)(3)(B)(ii), and 
A's basis in the C stock is determined by reference to the adjusted 
basis of A's purchased D stock under paragraph (e)(3) of this section. 
(Under paragraph (b)(2)(iii)(B)(3) of this section, the basis resulting 
from A's purchase of D stock is not eliminated solely for purposes of 
determining if the C stock acquired by A is disqualified stock 
immediately after the distribution, notwithstanding that paragraph 
(e)(3) of this section applies to the exchange.) Accordingly, the D 
stock and the C stock each is disqualified stock under section 355(d)(3) 
and paragraph (b)(2) of this section, and A is a disqualified person 
under paragraph (b)(3)(ii) of this section. The purposes of section 
355(d) under paragraph (b)(3)(i) of this section are violated because A 
increased its ownership in C from a 60 percent indirect interest to a 
100 percent direct interest, and because A's basis in the C stock is a 
purchased basis under paragraph (b)(3)(iii) of this section. 
Accordingly, the further distribution is a disqualified distribution 
under section 355(d)(2) and paragraph (b)(1) of this section.
    Example 4. Stock distributed in spin-off; purchased basis. D1 owns 
all the stock of C. D purchases all of the stock of D1 for cash. Within 
five years of D's purchase of D1, P acquires all of the stock of D1 from 
D in a section 368(a)(1)(B) reorganization that is not a reorganization 
under section 368(a)(1)(A) by reason of section 368(a)(2)(E), and D1 
distributes all of its C stock to P. P is treated as having acquired the 
D1 stock by purchase on the date D acquired it under the transferred 
basis rule of section 355(d)(5)(C) and paragraph (e)(2) of this section. 
P is treated as having purchased all of the C stock on the date D 
purchased the D1 stock under the attribution rules of section 355(d)(8) 
and paragraph (e)(1) of this section, and the C stock received by P is 
attributable to a distribution on purchased D1 stock under section 
355(d)(3)(B)(ii). Accordingly, the D1 and C stock each is disqualified 
stock under section 355(d)(3) and paragraph (b)(2) of this section, and 
P is a disqualified person under paragraph (b)(3)(ii) of this section. 
The purposes of section 355(d) under paragraph (b)(3)(i) of this section 
are violated. P did not increase direct or indirect ownership in D1 or 
C. However, P's basis in the C stock is a purchased basis under 
paragraph (b)(3)(iii) of this section because the D1 stock is not 
treated as acquired by purchase solely under the attribution rules of 
section 355(d)(8) and paragraph (e)(1) of this section. Accordingly, 
D1's distribution of the C stock to P is a disqualified distribution 
under section 355(d)(2) and paragraph (b)(1) of this section.

[[Page 216]]

    Example 5. Stock distributed in split-off with ownership increase; 
no purchased basis. P owns 50 percent of the stock of D, the remaining D 
stock is owned by unrelated persons, D owns all the stock of C, and A 
purchases all of the P stock from the P shareholders. Within five years 
of A's purchase, D distributes all of the C stock to P in exchange for 
P's D stock. A is treated as having purchased 50 percent of the stock of 
both D and C on the date A purchases the P stock under the attribution 
rules of section 355(d)(8) and paragraph (e)(1) of this section. The C 
stock received by P is attributable to a distribution on purchased D 
stock under section 355(d)(3)(B)(ii). Accordingly, the D stock and the C 
stock each is disqualified stock under section 355(d)(3) and paragraph 
(b)(2) of this section, and A is a disqualified person under paragraph 
(b)(3)(ii) of this section. The purposes of section 355(d) under 
paragraph (b)(3)(i) of this section are violated because, even though 
P's basis in the C stock is not a purchased basis under paragraph 
(b)(3)(iii) of this section, A increased its direct or indirect 
ownership in C from a 50 percent indirect interest to a 100 percent 
indirect interest. Accordingly, D's distribution of the C stock to P is 
a disqualified distribution under section 355(d)(2) and paragraph (b)(1) 
of this section.
    Example 6. Stock distributed in split-off with no ownership 
increase; no purchased basis. A purchases all of the stock of T. T later 
merges into D in a section 368(a)(1)(A) reorganization and A exchanges 
its purchased T stock for 60 percent of the stock of D. D owns all of 
the stock of D1 and D2, D1 and D2 each owns 50 percent of the stock of 
D3, and D3 owns all of the stock of C. Within five years of A's purchase 
of the T stock, D3 distributes the C stock to D1 in exchange for all of 
D1's D3 stock. A is treated as having acquired 60 percent of the D stock 
by purchase on the date A purchases the T stock under paragraph (e)(3) 
of this section. A is treated as having purchased 60 percent of the 
stock of D1, D2, D3, and C on the date A purchases the T stock under the 
attribution rules of section 355(d)(8) and paragraph (e)(1) of this 
section. The C stock received by D1 is attributable to a distribution on 
purchased D3 stock under section 355(d)(3)(B)(ii). Accordingly, the D3 
stock and the C stock each is disqualified stock under section 355(d)(3) 
and paragraph (b)(2) of this section, and A is a disqualified person 
under paragraph (b)(3)(ii) of this section. However, the purposes of 
section 355(d) under paragraph (b)(3)(i) of this section are not 
violated. A did not increase direct or indirect ownership in D3 or C, 
and D1's basis in the C stock is not a purchased basis under paragraph 
(b)(3)(iii) of this section because the D3 stock is treated as acquired 
by purchase solely under the attribution rules of section 355(d)(8) and 
paragraph (e)(1) of this section. Accordingly, D3's distribution of the 
C stock to D1 is not a disqualified distribution under section 355(d)(2) 
and paragraph (b)(1) of this section.
    Example 7. Purchased basis eliminated by liquidation; stock 
distributed in spin-off. P owns 30 percent of the stock of D, D owns all 
of the stock of D1, and D1 owns all of the stock of C. P purchases the 
remaining 70 percent of the D stock for cash. Within five years of P's 
purchase, P liquidates D in a transaction qualifying under sections 332 
and 337(a), and D1 then distributes the stock of C to P. Prior to the 
liquidation, P is treated as having purchased 70 percent of the stock of 
D1 and C on the date P purchases the D stock under the attribution rules 
of section 355(d)(8)(B) and paragraph (e)(1) of this section. After the 
liquidation, however, under paragraph (b)(2)(iii) of this section, P is 
not treated as having acquired by purchase the D1 or the C stock under 
section 355(d)(8)(B) and paragraph (e)(1) of this section because P's 
basis in the D stock is eliminated in the liquidation of D. Under 
section 334(b)(1), P's basis in the D1 stock is determined by reference 
to D's basis in the D1 stock and not by reference to P's basis in D. 
Paragraph (d)(2)(i)(B) of this section does not treat the D1 stock as 
newly purchased in P's hands because no gain or loss was recognized by D 
in the liquidation. Accordingly, neither the D1 stock nor the C stock is 
disqualified stock under section 355(d)(3) and paragraph (b)(2) of this 
section in P's hands, and the distribution is not a disqualified 
distribution under section 355(d)(2) and paragraph (b)(1) of this 
section.
    Example 8. Purchased basis eliminated by upstream merger; stock 
distributed in spin-off. D owns all of the stock of D1, and D1 owns all 
of the stock of C. P purchases 60 percent of the D stock for cash. 
Within five years of P's purchase, D merges into P in a section 
368(a)(1)(A) reorganization, with the D shareholders other than P 
receiving solely P stock in exchange for their D stock, and D1 then 
distributes the stock of C to P. Prior to the merger, P is treated as 
having purchased 60 percent of the stock of D1 and C on the date P 
purchases the D stock under the attribution rules of section 355(d)(8) 
and paragraph (e)(1) of this section. After the merger, however, under 
paragraph (b)(2)(iii) of this section, P is not treated as having 
acquired by purchase the D1 or the C stock under section 355(d)(8)(B) 
and paragraph (e)(1) of this section because P's basis in the D stock is 
eliminated in the merger. Under section 362(b), P's basis in the D1 
stock is determined by reference to D's basis in the D1 stock and not by 
reference to P's basis in D. Paragraph (d)(2)(i)(B) of this section does 
not treat the D1 stock as newly purchased in P's hands because no gain 
or loss was recognized by D in the merger. Accordingly, neither the D1 
stock nor the C stock is disqualified stock under section 355(d)(3) and 
paragraph (b)(2) of

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this section in P's hands, and the distribution is not a disqualified 
distribution under section 355(d)(2) and paragraph (b)(1) of this 
section.
    Example 9. Purchased basis eliminated by distribution; stock 
distributed in spin-off. A purchases all the stock of C for cash on Date 
1. D acquires all of the stock of C from A in a section 368(a)(1)(B) 
reorganization that is not a reorganization under section 368(a)(1)(A) 
by reason of section 368(A)(1)(E). A receives ten percent of the D stock 
in the transaction. The remaining D stock is owned by B. Within five 
years of A's purchase of the C stock, D distributes all the stock of C 
pro rata to A and B. Under the transferred basis rule of paragraph 
(e)(2) of this section, D is treated as having purchased all of the C 
stock on the date A acquired it. Under the exchanged basis rule of 
paragraph (e)(3) of this section, A is treated as having purchased its D 
stock on Date 1 and A is treated as having purchased ten percent of the 
C stock on Date 1 under the attribution rules of section 355(d)(8) and 
paragraph (e)(3) of this section. Moreover, under paragraph 
(b)(2)(iii)(C) of this section, A's basis in the C stock resulting from 
A's Date 1 purchase of C stock is eliminated. After the distribution, 
A's and B's bases in their C stock are determined by reference to the 
bases of their D stock under Sec. 1.358-2(a)(2) (and not by reference 
to D's basis in the C stock). D's basis in the stock of C resulting from 
its deemed purchase of that stock under paragraph (e)(2) of this section 
is eliminated by the distribution of the C stock because it would no 
longer be taken into account by any person in determining gain or loss 
on the sale of C stock. Therefore, the C stock distributed to A and B is 
not disqualified stock as a result of D's purchase of C. However, A's 
basis in its D stock resulting from its deemed purchase of that stock 
under paragraph (e)(3) of this section is not eliminated. Therefore, A's 
ten percent interest in the stock of D is disqualified stock. 
Furthermore, A's ten percent interest in the stock of C is disqualified 
stock because the distribution of the C stock is attributable to A's D 
stock that was acquired by purchase. However, there has not been a 
disqualified distribution because no person, immediately after the 
distribution, holds disqualified stock in either D or C that constitutes 
a 50 percent or greater interest in such corporation.
    Example 10. Allocation of purchased basis analyzed separately. --(i) 
P owns all the stock of D. D purchases all the stock of D1 for cash on 
Date 1. D1 owns all the stock of C (which owns all the stock of C1) and 
S. Within five years of Date 1, D1 distributes all the stock of C to D. 
The D1 and C stock each is disqualified stock under section 355(d)(3) 
and paragraph (b)(2) of this section, and D is a disqualified person 
under paragraph (b)(3)(ii) of this section. The purposes of section 
355(d) under paragraph (b)(3)(i) of this section are violated. D did not 
increase direct or indirect ownership in D1 or C. However, D's basis in 
the C stock is a purchased basis under paragraph (b)(3)(iii) of this 
section because the D1 stock is not treated as acquired by purchase 
solely under the attribution rules of section 355(d)(8) and paragraph 
(e)(1) of this section. Accordingly, the distribution is a disqualified 
distribution under section 355(d) and paragraph (b)(1) of this section. 
D's basis in the D1 stock is allocated pursuant to Sec. 1.358-2 between 
the D1 stock and the C stock. Therefore, under paragraph (e)(4) of this 
section, the C stock is deemed to be acquired by purchase on Date 1, the 
date D purchased all the stock of D1. If thereafter, and within five 
years of Date 1, C were to distribute all the stock of C1 to D, that 
distribution would also be a disqualified distribution because of D's 
deemed purchase of the stock of C.
    (ii) Following the distribution of the stock of C by D1, and within 
five years of Date 1, D distributes all the stock of D1 to P. Under 
paragraph (b)(2)(iii)(D) of this section, the determination of whether 
D's basis in D1 has been eliminated shall be made without regard to D's 
allocated basis in C. After the distribution, P's basis in the D1 stock 
is determined by reference to its basis in its D stock under Sec. 
1.358-2(a)(2) (and not by reference to D's basis in the D1 stock). D's 
basis in the D1 stock resulting from the purchase of that stock is 
eliminated by the distribution of the D1 stock because it would no 
longer be taken into account by any person in determining gain or loss 
on the sale of D1 stock. Therefore, the D1 stock distributed to P is not 
disqualified stock as a result of D's purchase of D1. Moreover, a 
subsequent distribution of the S stock by D1 to P would not be a 
disqualified distribution because both the D1 and S stock would cease to 
be treated as purchased when D's basis in D1 has been eliminated.

    (4) Anti-avoidance rule--(i) In general. Notwithstanding any 
provision of section 355(d) or this section, the Commissioner may treat 
any distribution as a disqualified distribution under section 355(d)(2) 
and paragraph (b)(1) of this section if the distribution or another 
transaction or transactions are engaged in or structured with a 
principal purpose to avoid the purposes of section 355(d) or this 
section with respect to the distribution. Without limiting the preceding 
sentence, the Commissioner may determine that the existence of a related 
person, intermediary, pass-through entity, or similar person (an 
intermediary) should be disregarded, in whole or in part, if the

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intermediary is formed or availed of with a principal purpose to avoid 
the purposes of section 355(d) or this section.
    (ii) Example. The following example illustrates this paragraph 
(b)(4):

    Example. Post-distribution redemption. B wholly owns D, which wholly 
owns C. With a principal purpose to avoid the purposes of section 
355(d), A, B, D, and C engage in the following transactions. A purchases 
45 of 100 shares of the only class of D stock. Within five years after 
A's purchase, D distributes all of its 100 shares in C to A and B pro 
rata. D then redeems 20 shares of B's D stock, and C redeems 20 shares 
of B's C stock. After the redemption, A owns 45 shares and B owns 35 
shares in each of D and C. Under paragraph (b)(4)(i) of this section, 
the Commissioner may treat A as owning disqualified stock in D and C 
that constitutes a 50 percent or greater interest in D and C immediately 
after the distribution. Under that treatment, the distribution is a 
disqualified distribution under section 355(d)(2) and paragraph (b)(1) 
of this section.

    (c) Whether a person holds a 50 percent or greater interest--(1) In 
general. Under section 355(d)(4), 50 percent or greater interest means 
stock possessing at least 50 percent of the total combined voting power 
of all classes of stock entitled to vote or at least 50 percent of the 
total value of shares of all classes of stock.
    (2) Valuation. For purposes of section 355(d)(4) and this section, 
all shares of stock within a single class are considered to have the 
same value. But see paragraph (c)(3)(vii)(A) of this section 
(determination of whether it is reasonably certain that an option will 
be exercised).
    (3) Effect of options, warrants, convertible obligations, and other 
similar interests--(i) Application. This paragraph (c)(3) provides rules 
to determine when an option is treated as exercised for purposes of 
section 355(d) (other than section 355(d)(6)). Except as provided in 
this paragraph (c)(3), an option is not treated as exercised for 
purposes of section 355(d). This paragraph (c)(3) does not affect the 
determination of whether an instrument is an option or stock under 
general principles of tax law (such as substance over form).
    (ii) General rule. In determining whether a person has acquired by 
purchase a 50 percent or greater interest under section 355(d)(4), an 
option to acquire stock (as described in paragraphs (c)(3)(v) and (vi) 
of this section) that has not been exercised when a distribution occurs 
is treated as exercised on the date it was issued or most recently 
transferred if--
    (A) Its exercise (whether by itself or in conjunction with the 
deemed exercise of one or more other options) would cause a person to 
become a disqualified person; and
    (B) Immediately after the distribution, it is reasonably certain (as 
described in paragraph (c)(3)(vii) of this section) that the option will 
be exercised.
    (iii) Options deemed newly issued and substituted options--(A) 
Exchange, adjustment, or alteration of existing option. For purposes of 
this paragraph (c)(3), each of the following is treated as a new 
issuance or transfer of an existing option only if it materially 
increases the likelihood that an option will be exercised--
    (1) An exchange of an option for another option or options;
    (2) An adjustment to the terms of an option (including an adjustment 
pursuant to the terms of the option);
    (3) An adjustment to the terms of the underlying stock (including an 
adjustment pursuant to the terms of the stock);
    (4) A change to the capital structure of the issuing corporation; 
and
    (5) An alteration to the fair market value of issuing corporation 
stock through an asset transfer (other than regular, ordinary dividends) 
or through any other means.
    (B) Certain compensatory options. An option described in paragraph 
(c)(3)(vi)(B)(2) of this section is treated as issued on the date it 
becomes transferable.
    (C) Substituted options. If an option (existing option) is exchanged 
for another option or options (substituted option or options) and 
paragraph (c)(3)(iii)(A) of this section does not apply to treat such 
exchange as a new issuance or transfer of the existing option, the 
substituted option or options will be treated as issued or most recently 
transferred on the date that the existing option was issued or most 
recently transferred.

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    (iv) Effect of treating an option as exercised--(A) In general. For 
purposes of section 355(d), an option that is treated as exercised under 
this paragraph (c)(3) is treated as exercised both for purposes of 
determining the percentage of the voting power of stock owned by the 
holder and for purposes of determining the percentage of the value of 
stock owned by the holder.
    (B) Stock purchase agreement or similar arrangement. If a stock 
purchase agreement or similar arrangement is deemed exercised, the 
purchaser is treated as having purchased the stock under the terms of 
the agreement or arrangement as though all covenants had been satisfied 
and all contingencies met. The agreement or arrangement is deemed to 
have been exercised as of the date it is entered into or most recently 
assigned.
    (v) Instruments treated as options. For purposes of this paragraph 
(c)(3), except to the extent provided in paragraph (c)(3)(vi) of this 
section, the following are treated as options: A call option, warrant, 
convertible obligation, the conversion feature of convertible stock, put 
option, redemption agreement (including a right to cause the redemption 
of stock), notional principal contract (as defined in Sec. 1.446-3(c)) 
that provides for the payment of amounts in stock, stock purchase 
agreement or similar arrangement, or any other instrument that provides 
for the right to purchase, issue, redeem, or transfer stock (including 
an option on an option).
    (vi) Instruments generally not treated as options. For purposes of 
this paragraph (c)(3), the following are not treated as options, unless 
issued, transferred, or listed with a principal purpose to avoid the 
application of section 355(d) or this section:
    (A) Escrow, pledge, or other security agreements. An option that is 
part of a security arrangement in a typical lending transaction 
(including a pu