[Federal Register Volume 59, Number 156 (Monday, August 15, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-19548]


[[Page Unknown]]

[Federal Register: August 15, 1994]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8560]
RIN 1545-AQ69

 

Consolidated Returns--Stock Basis and Excess Loss Accounts, 
Earnings and Profits, Absorption of Deductions and Losses, Joining and 
Leaving Consolidated Groups, Worthless Stock Loss, Nonapplicability of 
Section 357(c)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations amending the 
consolidated return investment adjustment system, including the rules 
for earnings and profits and excess loss accounts. The amendments 
delink the adjustments to stock basis from the adjustments to earnings 
and profits. Stock basis is adjusted under rules similar to the rules 
for adjusting the basis of partnership interests and stock in S 
corporations, and earnings and profits are adjusted under a separate, 
parallel system. Amendments are also made to the rules limiting 
absorption of a member's deductions and losses when it leaves a 
consolidated group, modifying the stock basis and earnings and profits 
of members in certain group structure changes, allocating a 
corporation's tax items for the year it joins or leaves a consolidated 
group, allowing a worthless stock loss deduction with respect to the 
stock of members, and applying section 357(c) to transactions between 
members.

DATES: These regulations are effective January 1, 1995.
    For dates of applicability, see the ``Effective dates'' section 
under the SUPPLEMENTARY INFORMATION portion of the preamble.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations relating to 
stock basis, excess loss accounts, and earnings and profits generally, 
absorption of deductions and losses, worthless stock loss and the 
nonapplicability of section 357(c), Steven B. Teplinsky, (202) 622-
7770; concerning the regulations relating to group structure changes, 
Rose L. Williams (202) 622-7550; and concerning the regulations 
relating to the allocation of items for the year a corporation joins or 
leaves a group, Roy A. Hirschhorn, (202) 622-7770. (These numbers are 
not toll-free numbers.)

SUPPLEMENTARY INFORMATION:

A. Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the requirements of the Paperwork Reduction Act (44 
U.S.C. 3504(h)) under control number 1545-1344. The estimated average 
annual burden per respondent is .6 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.

B. Background

    This document contains final regulations for adjusting the stock 
basis and earnings and profits (E&P) of members of consolidated groups, 
and related rules.
    Proposed regulations were issued in a Notice of Proposed Rulemaking 
published in the Federal Register on November 12, 1992. See 57 FR 
53634. In addition to the originally scheduled public hearing, a second 
hearing was scheduled in a Notice of Additional Public Hearing on 
Proposed Regulations published in the Federal Register on November 23, 
1992. See 57 FR 54957. In Notice 92-59, 1992-2 C.B. 386, the IRS 
delayed the repeal of the 30-day rules so that they would continue to 
apply to corporations becoming or ceasing to be members before February 
15, 1993.
    The IRS received many comments on the proposed regulations 
addressing both policy and technical matters, and held public hearings 
on December 18, 1992 and March 4, 1993. After consideration of the 
comments and the statements made at the hearings, the proposed 
regulations are adopted as modified by this Treasury decision. The 
modifications, as well as several comments and suggestions that are not 
adopted in the final regulations, are discussed below.
    No inference is intended by the final regulations as to the 
operation of the current regulations.

C. The Proposed and Final Regulations

    The final regulations retain the general approach of the proposed 
regulations, delinking stock basis adjustments from E&P adjustments and 
operating through uniform rules of general application rather than 
through mechanical rules. However, numerous changes have been made to 
clarify the regulations and to conform their style to that of other 
recent consolidated return regulations.

1. Delinking Stock Basis and E&P

    The investment adjustment system of the current regulations 
requires an owning member (P) to adjust its basis in the stock of a 
subsidiary (S) to reflect S's current E&P (or E&P deficit). P's basis 
is also generally reduced by the amount of any dividend distributions 
by S to P. The adjustments have the effect of treating P and S as a 
single entity. To the extent E&P includes amounts such as tax-exempt 
interest income, the adjustments prevent the income from being taxed 
indirectly on the disposition of S's stock.
    After S's E&P is taken into account by P in adjusting its basis in 
S's stock, the stock basis adjustment is taken into account to adjust 
P's own E&P. This adjustment ensures that S's E&P is taken into account 
by P for purposes of further stock basis adjustments if P is not the 
common parent, and for distributions by P to nonmembers.
    The current regulations were adopted in 1966. It was appropriate at 
that time to link stock basis and E&P adjustments because the 
modifications to taxable income required to compute E&P were generally 
also necessary to compute stock basis. Differences between taxable 
income and E&P have substantially increased since 1966, however, and 
many changes in the rules for determining E&P are not appropriate to 
the determination of stock basis. The resulting confusion and conflict 
is evidenced by recent cases examining the investment adjustment 
system.
    Section 1503(e) corrects many investment adjustment distortions 
resulting from the divergence of taxable income and E&P. It requires P 
to redetermine its basis in S's stock under modified rules at the time 
the stock is disposed of. The modifications eliminate the original 
rationale for a system linking stock basis to E&P. Moreover, because 
the modifications are not generally integrated into the investment 
adjustment regulations, significant complexity has resulted.
    The proposed regulations comprehensively revise the investment 
adjustment system by delinking stock basis adjustments from E&P 
adjustments. Stock basis adjustments are determined by reference to a 
modified computation of S's taxable income, rather than to S's E&P. S's 
E&P continues to tier up to P, but under a separate E&P adjustment 
system. Separating the stock basis and E&P adjustment systems 
implements the intent of section 1503(e) and prevents policies specific 
to one system from distorting the other.
    Some commentators argued that the current E&P-based system is 
simpler because it is familiar to practitioners, even though it 
requires taxpayers to determine investment adjustments first by 
reference to E&P, then by incorporating modifications under current 
regulations, and finally by incorporating modifications under the Code. 
These commentators contended that the effect of transactions on E&P was 
usually clear, and that changing the system resulted in more, rather 
than less, uncertainty. Most commentators, however, agreed that 
delinking stock basis and E&P is appropriate.
    The E&P system is fundamentally concerned with measuring dividend 
paying capacity, while the investment adjustment system is concerned 
with measuring consolidated taxable income. The current system is 
overly complex because it provides different rules for different 
sources of E&P, the effect of many transactions on E&P is uncertain, 
and the E&P rules are already overridden by temporary consolidated 
return regulations and later enacted Code provisions. By contrast, 
proper investment adjustments for most subsidiaries under the proposed 
regulations generally will equal the change in the subsidiary's net 
asset basis for tax purposes during the period that it is a member.
    One example of the distortions under the current regulations is the 
effect of S's unabsorbed loss on P's E&P. The positive investment 
adjustment for unabsorbed losses correctly prevents P's basis in S's 
stock from being reduced while the loss is carried over. However, 
because P's E&P is adjusted by the amount of the adjustment to P's 
basis in S's stock, the adjustment also has the effect of preventing 
P's E&P from reflecting S's loss even though the dividend paying 
capacity of the group has diminished. Thus, the proper timing of stock 
basis and E&P adjustments is in conflict. The distortion is increased 
if the amount of S's tax loss and E&P deficit do not correspond, and 
uncertainty is created if the loss has a special status.
    Investment adjustments under the proposed regulations generally are 
based on items calculated annually and reflected in a taxpayer's tax 
return or permanent records, rather than on E&P items that may never 
have been calculated or recorded. Although the current regulations 
require taxpayers to adjust stock basis annually, annual E&P 
computations are otherwise generally unnecessary and commentators 
generally agree that most groups fail to make the adjustments annually. 
If stock basis adjustments are not determined until stock is to be 
disposed of, costly E&P studies are required to calculate items from 
prior periods for which records may no longer be available.
    Even if S attempts to calculate its E&P annually for purposes of 
the current regulations, that calculation is subject to uncertainty in 
many cases despite the development over the years of a substantial body 
of E&P guidance. See, e.g., section 312(h) and Secs. 1.312-10 and 
1.312-11 (E&P allocations in corporate separations and 
reorganizations). New transactions and Code provisions continue to 
develop and require E&P guidance.
    Because the proposed regulations delink stock basis and E&P 
determinations, the policies influencing the development of E&P rules 
no longer affect the unrelated and potentially conflicting policies for 
stock basis adjustments. Section 1503(e) already mandates separate 
computations for purposes of adjusting stock basis and E&P, and the 
growing disparity between taxable income and E&P may preclude taxpayers 
from relying on E&P guidance in many instances. See, e.g., section 
1503(e)(1)(B). Consequently, the best approach to the investment 
adjustment system is to begin the computation with taxable income or 
loss and make adjustments. Compare the systems for adjusting the basis 
of partnership interests (section 705) and stock in S corporations 
(section 1367).
    The final regulations retain the approach of the proposed 
regulations. Investment adjustments are determined by reference to (i) 
taxable income or loss, (ii) tax-exempt income, (iii) noncapital, 
nondeductible expenses, and (iv) distributions.

2. Taxpayers' Ability To Override Specific Rules

    Many of the proposed regulation sections begin with a general 
statement of the purposes of the section. Most commentators supported 
these statements. Commentators suggested that taxpayers should be able 
to use them to override specific rules (i) in general, (ii) if failure 
to override would result in duplicating items, (iii) if the taxpayer 
discloses the override in its return, or (iv) if the taxpayer receives 
an expedited ruling from the IRS expressly allowing the override (under 
procedures to be established). Some commentators suggested that the IRS 
should also have the authority to override specific rules in certain 
circumstances, and that the circumstances justifying an IRS override 
could be broader than those justifying a taxpayer override.
    The proposed statements of purposes were intended to prevent the 
recurrence of historic problems associated with literal application of 
the consolidated return regulations, and they are retained in the final 
regulations. However, commentators expressed a diversity of views as to 
how the regulations could be interpreted to serve taxpayer purposes. 
Consequently, the final regulations do not authorize taxpayers to 
deviate from specific rules, except to prevent duplication of 
adjustments. For example, a negative stock basis adjustment is not made 
under section 301(c)(2) if the adjustment has already been taken into 
account under the final regulations.
    The proposed regulations also contain statements describing rules 
of construction and identify factors to be weighed in making 
adjustments. Commentators requested that these statements and factors 
be clarified. The statements and factors are not retained in the final 
regulations because they merely restate generally applicable rules of 
construction. The final regulations remain subject to generally 
applicable rules of construction.

3. Negative Adjustments

    In addition to reducing stock basis for tax losses, the proposed 
regulations reduce stock basis for noncapital, nondeductible amounts 
such as Federal income taxes, and for distributions. The IRS received 
numerous comments on specific applications of these adjustments, 
particularly the negative adjustments for expiring losses and for 
distributions of E&P from years when S was affiliated with P but filed 
separate returns.
    The proposed regulations provide that noncapital, nondeductible 
expenses result in negative adjustments. Like positive adjustments for 
tax-exempt income, these negative adjustments are necessary to preserve 
the treatment of items under the Code. Similar treatment is required 
for certain direct, permanent adjustments to the basis of S's assets. 
For example, a reduction in the basis of S's assets under section 50(c) 
must be reflected by a corresponding reduction in P's basis in S's 
stock.
a. Expiring Losses
    Many comments were received on the negative adjustment for the 
expiration of S's loss carryovers. Commentators generally agreed that 
losses arising while S is a member of the group should be treated as 
noncapital, nondeductible amounts in the year they expire, but 
disagreed with this treatment for losses that arose before S became 
affiliated with P.
    For example, if P forms S with a $100 capital contribution and S 
generates a $60 net operating loss (NOL) carryover, P's basis in S's 
stock remains $100 under the proposed regulations. If the NOL 
subsequently expires under section 172, the expiration is a noncapital, 
nondeductible expense upon the expiration because S's loss is 
effectively disallowed at that time. P's basis in S's stock must be 
reduced to prevent the loss from effectively being preserved in the 
basis. Commentators generally agreed with this result, and it conforms 
to the results for partners and S corporation shareholders whose loss 
carryovers expire.
    If instead P buys existing S stock for $100, and at that time S's 
assets have a $40 basis and value and S has a $60 NOL, many 
commentators argued that P's $100 cost basis in the S stock does not 
reflect the $60 NOL and that the NOL's subsequent expiration therefore 
should not reduce P's basis in the S stock (or should reduce basis only 
to a limited extent). No principles have been identified to distinguish 
an expiring NOL from other noncapital, nondeductible amounts that 
reduce P's basis in S's stock. Moreover, no meaningful distinction has 
been found between the case in which S has a separate built-in loss (in 
the form of the NOL) that corresponds to its built-in gain and the case 
in which S has no built-in loss or gain at the time of P's acquisition 
and S subsequently produces corresponding gain and an NOL that expires.
    Some commentators acknowledged that, if S has a $60 NOL and $60 of 
corresponding built-in gain, as much as $21 of P's cost basis in S's 
stock may reflect the NOL (35% of $60), but suggested that much less 
than $21 is likely to be reflected, particularly if the use of the NOL 
is limited under section 382. These commentators suggested that the 
analysis should shift to determining possible after-tax benefits of the 
NOL to the P group that might be reflected in P's cost basis in S's 
stock (i.e., P's negative adjustment would be limited to the amount 
paid by P for the NOL--an amount not to exceed $21).
    The final regulations do not adopt this suggestion. Determining 
after-tax amounts accurately is inherently complex. In addition, there 
is no apparent reason why adjustments for absorption of the NOL should 
differ from those for expiration of the NOL, or why subsequent positive 
adjustments for S's built-in gain should not also increase basis by 
only an after-tax amount. For example, although S's $60 built-in gain 
would be fully subject to tax following repeal of the General Utilities 
doctrine, commentators did not suggest that P's basis should be 
increased by only $39 for the gain (65% of $60, or $60 minus a $21 
discount in the purchase price of the S stock to reflect the built-in 
tax).
    Almost all commentators argued that a negative adjustment is 
inappropriate in some cases. For example, if P buys existing S stock 
for $40, and at that time S's assets have a $40 basis and value and S 
has a $60 NOL, commentators argued that the expiration of the NOL 
should not reduce P's basis in the S stock (to a $20 excess loss 
account) because P's $40 cost basis in the S stock does not reflect the 
$60 NOL.
    Commentators identified the following general cases in which a 
negative adjustment may be warranted: (i) if S incurs the loss after P 
purchases the S stock (because P's basis in the stock reflects an 
amount corresponding to the NOL); (ii) if P acquires S stock in a 
carryover basis transaction (because P may succeed to a prior 
shareholder's stock basis reflecting the NOL); and (iii) if P 
indirectly acquires S stock by purchasing S's parent (because the 
parent's basis in S's stock may reflect the NOL).
    The proposed regulations do not predicate stock basis adjustments 
on presumptions as to whether amounts are already reflected in stock 
basis. Instead, they reflect the treatment under the Code of all 
changes in S's net asset basis while S is a member. Substantially 
altering this approach to take additional information into account 
would require significant modifications, including appraisals and 
tracing.
    Nevertheless, the IRS and the Treasury Department believe that 
certain cases merit relief. For example, if P buys S's stock and S has 
a large NOL carryover subject to a section 382 limitation, expiration 
of the NOL could easily result in an unavoidable negative adjustment 
even though the NOL was of limited value. Solutions suggested by 
commentators included (i) never providing a negative adjustment (even 
if the NOL arises in P's group) because there is no tax benefit for the 
expiration, (ii) limiting the negative adjustment to $.35 for every $1 
of NOL (based on the highest marginal tax rate), (iii) requiring a 
negative adjustment only if S becomes a member after the proposed 
regulations are finalized (or only if the NOL expires after the 
proposed regulations are finalized), (iv) limiting the negative 
adjustment to prevent it from reducing P's basis in S's stock below S's 
net asset basis immediately after the expiration, and (v) permitting P 
to waive S's NOL before S becomes a member (thereby preventing the NOL 
from expiring while P owns S).
    The final regulations generally retain the proposed rule requiring 
a negative stock basis adjustment for expiring losses. However, the 
final regulations provide a special rule allowing an acquiring group to 
waive S's loss carryovers from separate return limitation years. In 
addition, if S became a member of a group before the effective date of 
the final regulations and had a loss carryover from a separate return 
limitation year at that time, a special rule provides that the group is 
not required to treat expiration of the loss carryover as a negative 
adjustment under this section (although if S becomes a member of a 
second group after the effective date and the loss carryover expires 
while S is a member of the second group, the special rule does not 
apply).
    To more fully integrate expired losses into the investment 
adjustment system, the final regulations also add special rules 
treating expired loss carryovers as continuing to exist for purposes of 
determining whether a positive adjustment is permitted for cancellation 
of indebtedness income and whether an excess loss account must be taken 
into account because of S's worthlessness.
    To waive a loss carryover, the final regulations require the group 
to identify the amount waived (or the amount not waived) in a statement 
filed with the group's consolidated return for the year S becomes a 
member. The group may waive any carryover that it chooses, and may 
waive amounts carried from different years. However, the final 
regulations do not permit groups to identify the waived amount (or the 
unwaived amount) through formulas. Comments are solicited as to whether 
the use of formulas should be permitted and as to any other rules that 
should be adopted in subsequent IRS guidance.
b. Adjustments for All Distributions
    Because stock basis adjustments under the proposed regulations 
generally conform to changes in S's net asset basis, and S's 
distribution of $1 always decreases S's net asset basis by $1, the 
proposed regulations require that all distributions by S reduce P's 
basis in S's stock. By contrast, the current regulations do not reduce 
basis for distributions of E&P earned in affiliated, nonconsolidated 
years. Because the proposed rule is a significant change from current 
law, the proposed regulations require negative adjustments for 
distributions of this E&P only if the distribution is made after the 
proposed regulations are adopted.
    Many commentators argued that no negative adjustment should be 
required for distributions by S of E&P from affiliated, nonconsolidated 
years. They viewed the approach of the current regulations as 
preferable because (i) no positive adjustment is made when the E&P is 
earned, (ii) sections 243 and 1502 were intended to reach comparable 
results for nonconsolidated and consolidated groups with respect to 
affiliated, nonconsolidated E&P, and section 243 allows a 100% 
dividends received deduction to nonconsolidated groups without a basis 
reduction, and (iii) section 1059 was intended by Congress to be the 
only source of additional basis reductions. Moreover, although 
taxpayers could avoid the proposed negative adjustment by making a 
distribution during the last separate return year, commentators 
maintained that the proposed negative adjustment was a trap for 
taxpayers unable or unwilling to make distributions before joining in a 
consolidated return.
    Commentators advocated preserving the approach of the current 
regulations by providing an exception for distributions of E&P 
accumulated in affiliated, nonconsolidated years. Such an exception 
would require determining the amount of modified taxable income for 
investment adjustment purposes that corresponds to the E&P, and 
providing rules relating that income to the distributed E&P. Although 
section 301(e) already modifies the applicable E&P, additional 
modifications would be required to determine the modified taxable 
income under the proposed regulations for particular subsidiaries.
    Preserving separate return treatment for distributions during 
consolidated return years is increasingly inappropriate as more 
distinctions are made under the Code and regulations between 
corporations filing separate and consolidated returns. The proposed 
regulations maintain the distinctions between separate and consolidated 
returns by effectively preserving the separate return double tax system 
for E&P not distributed in separate return years.
    The absence of a negative adjustment under the current regulations 
appears to be based on a presumption that the distributed E&P is not 
reflected in stock basis. This presumption may be wrong if, for 
example, P purchases S's stock after the E&P economically accrues but 
before it is taken into account for Federal income tax purposes. To 
limit the negative adjustment would be inconsistent with the general 
approach of the regulations because it would require appraisals and 
tracing of E&P to provide different stock basis reductions depending on 
the nature of the distributed E&P.
    Commentators also suggested that requiring a negative adjustment 
for distributions could be appropriate if the regulations also provided 
that P's basis in S's stock was automatically or electively adjusted in 
S's first consolidated return year to reflect S's E&P from affiliated, 
nonconsolidated years. Where taxpayers fail to make distributions in 
consolidated return years, however, the adjustment would have the 
effect of positive investment adjustments for earnings in separate 
return years even though the consolidated return rules do not generally 
apply to those years. This approach would have the effect of 
inappropriately applying a portion of the consolidated return rules to 
periods for which separate returns are filed.
    Accordingly, the final regulations retain the requirement of a 
negative stock basis adjustment for all distributions. However, S's 
stock basis is not reduced as a result of a distribution of E&P 
accumulated in separate return years, if the distribution is made in a 
tax year beginning before January 1, 1995 and the distribution does not 
cause a negative adjustment under the investment adjustment rules in 
effect at the time of the distribution.

4. Allocation of Adjustments

    The proposed regulations provide limited rules for allocating stock 
basis adjustments to different shares of stock. Allocation issues arise 
if, for example, P owns less than all of S's stock, S has more than one 
class of stock, P's interest in S varies, or P has different bases in 
different blocks of S's stock.
    The allocation rules of the proposed regulations are similar in 
effect to those of the current regulations. Under the proposed 
regulations, however, stock basis adjustments must be cumulatively 
redetermined whenever necessary to determine the tax liability of any 
person.
    Most commentators agreed that the proposed allocation rules provide 
greater guidance than the current regulations. Commentators had mixed 
views on the proposed cumulative redetermination rule. Some stated that 
cumulative redeterminations are complex, but are nevertheless 
economically sound and appropriate. Others stated that taxpayers should 
not be required to redetermine their basis because the requirement is 
inconsistent with the proposed annual basis adjustment statement and 
imposes undue administrative difficulties on taxpayers. However, 
specific problems that would commonly result in undue difficulties were 
not identified.
    The final regulations retain the allocation system of the proposed 
regulations, including the cumulative redetermination rule, but provide 
additional guidance for cumulative redeterminations. See ``Annual 
reporting requirement,'' discussed at C.7. of this preamble, for the 
elimination of the annual reporting requirement.

5. Election to Reallocate Basis

    The current regulations provide that if P disposes of S stock with 
an excess loss account, P may avoid including the excess loss account 
in income by electing to reduce its basis in any retained S stock or 
debt by an amount equal to the excess loss account. This election was 
substantially limited by section 1503(e)(4) and by recent amendments to 
the consolidated return regulations, and its remaining scope is 
unclear.
    The proposed regulations eliminate the election. Negative 
adjustments (other than for distributions) are not allocated to 
preferred stock because of its similarity to debt, which receives no 
negative adjustments. S's losses should not be allocated to preferred 
shares until S is unable to satisfy their priority. S's ability to 
satisfy their priority can only be determined with appraisals, and the 
use of appraisals is contrary to the general approach of the 
regulations.
    Commentators requested that the election be retained. The most 
common use of the election is where P holds both common and preferred 
stock of S, because all of S's negative adjustments are allocated to 
its common stock. The rationale for an election in these cases is to 
permit P to avoid income from an excess loss account in the common 
stock that may be attributable to P's investment in the preferred 
stock.
    However, P's investment in S's preferred stock is distinct from its 
investment in common stock. If negative adjustments should not be 
initially allocated to the preferred stock (or reallocated on a 
cumulative redetermination), they should not effectively be reallocated 
to the preferred stock through an election.
    In view of the limited scope of the election, the increased ability 
of the allocation rules to reflect economic interests, and the 
limitations on allocating negative adjustments to preferred stock, the 
final regulations continue the approach of the proposed regulations and 
eliminate the basis reallocation election of current law.

6. Anti-Avoidance Rules

    The proposed investment adjustment regulations require overriding 
adjustments to carry out the purposes of the regulations if any person 
acts with a principal purpose to avoid the effect of the regulations, 
or uses the regulations to avoid the effect of any other provision of 
the consolidated return regulations. More specific rules are provided 
to take into account any difference between the basis and value of 
property transferred to (or from) S, and to continue making adjustments 
if a corporation becomes a nonmember. Commentators criticized the 
uncertainty caused by the proposed overriding adjustment rules.
    Anti-avoidance rules are necessary if the regulations are to 
operate through uniform rules of general application that are subject 
to interpretation and juxtaposition with other rules. Because the 
purposes of the regulations are identified, taxpayers generally should 
be aware of inappropriate results. Limiting circumvention of the 
regulations through transactions having a principal purpose of 
avoidance is consistent with other recent consolidated return guidance 
and with regulations issued under Code provisions applicable to 
separate return taxpayers.
    The final regulations retain the general approach of the proposed 
regulations but operate through a single rule. Many of the proposed 
examples are modified to reflect comments, and examples of permitted 
avoidance of the rules are added. In the new examples, all relevant 
aspects of the transactions take place under separate return rules, so 
that avoidance of the regulations is not inconsistent with the purposes 
of the regulations.

7. Annual Reporting Requirement

    To ensure more accurate determinations of stock basis adjustments, 
the proposed regulations require that a statement be included in each 
year's return identifying the adjustments for that year. This annual 
reporting requirement was proposed because of the concern that most 
groups do not determine the amount of their investment adjustments 
annually as required by the current regulations and do not maintain 
adequate records to make accurate determinations at a later date. 
Ultimately, these groups determine stock basis through elaborate but 
often unreliable E&P studies performed in connection with a later stock 
disposition.
    Commentators differed in their views on the proposed annual 
reporting requirement. While some agreed that the additional burden was 
worth the potential improvement in compliance with the annual 
adjustment requirement and in the accuracy of the adjustments, others 
contended that the information contained in the annual statements would 
not be useful. They asserted that (i) the reporting would be burdensome 
because it would be required for all subsidiaries even though many 
would never be disposed of, (ii) collecting information relevant only 
for future determinations of tax liability would do little to improve 
the accuracy of investment adjustments, and (iii) the lack of a 
noncompliance penalty would lead to noncompliance with the reporting 
requirement or to faulty reporting.
    The final regulations do not retain the proposed annual reporting 
requirement. The elimination of the proposed reporting requirement does 
not, however, reflect acceptance of the view that taxpayers need not 
make investment adjustments annually. There is continuing concern that 
investment adjustments often are not determined with reasonable 
accuracy, particularly in the case of long-held subsidiaries.
    To increase the accuracy of investment adjustment determinations 
(and the ability to examine the group's returns based on those 
determinations), the final regulations expressly require taxpayers to 
maintain annual books and records necessary for accurate stock basis 
adjustments. This requirement is consistent with section 6001, which 
generally requires taxpayers to keep those records that the Secretary 
deems necessary to determine tax liability. Taxpayers are cautioned 
that they are subject to penalties for tax underpayments resulting 
from, among other things, negligence or substantial or gross 
misstatements of the adjusted basis of any property (including stock of 
subsidiaries). See, e.g., section 6662 (c), (e), and (h).

8. E&P Adjustments

a. General Rules
    The proposed regulations tier up E&P directly from S to P under a 
system separate from, but parallel to, the stock basis adjustment 
system. By separating the two systems, the possibility of phantom E&P 
adjustments resulting from the stock basis rules is eliminated.
    If S earns E&P in a consolidated return year, the E&P tiers up 
under the proposed regulations directly and is included in P's E&P. If 
S later distributes the E&P to P, P's E&P does not further increase 
because P's dividend income is offset by a decrease for the tier up of 
S's E&P reduction under section 312 from the distribution.
    The proposed regulations generally did not intend to permit the 
complete elimination of S's E&P from affiliated, nonconsolidated years 
by offsetting P's dividend income with S's E&P reduction from the 
distribution. S's affiliated, nonconsolidated E&P was not included in 
P's E&P when earned (because no tier up occurs in affiliated, 
nonconsolidated years), and if it is not included in P's E&P when 
distributed, it would be eliminated entirely. Commentators questioned 
this result because it cannot be achieved under the Code if separate 
returns are filed and is inconsistent with both single entity and 
separate entity treatment of P and S.
    Both the current and the proposed regulations permit E&P 
distributed by S to be eliminated if the E&P was earned in years before 
S became affiliated with P (SRLY E&P). Elimination of SRLY E&P is also 
possible under separate return rules. Because P generally has no 
negative stock basis adjustment for separate return distributions by S, 
P's E&P from the dividend ultimately may be offset by an E&P deficit 
(or less E&P) from a later disposition of S's stock. Whether the 
elimination of SRLY E&P is correct depends on the extent to which the 
E&P is already reflected in P's E&P. However, the elimination of 
affiliated, nonconsolidated E&P is incorrect.
    The final regulations generally retain the approach of the proposed 
regulations. However, the final regulations provide additional rules to 
prevent the elimination of S's affiliated, nonconsolidated E&P by its 
distribution to P during a consolidated return year.
b. Dividend Stripping
    Several rules of the proposed regulations limit P's ability to 
obtain unintended tax benefits by avoiding negative basis adjustments 
for certain distributions from S while claiming the dividends received 
deduction for the distributions. For example, (i) P takes into account 
S's distribution to which section 301 applies when P becomes entitled 
to the distribution (generally on the record date), (ii) S's E&P is 
eliminated immediately before S becomes a nonmember to the extent the 
E&P is reflected by another member under the proposed regulations, and 
(iii) if P succeeds another corporation as the common parent of a 
group, P's E&P is adjusted immediately after it becomes the new common 
parent to reflect the E&P of the former common parent.
    The final regulations retain the approach of the proposed 
regulations. However, the final regulations apply the distribution 
entitlement rule for all Federal income tax purposes (not just for 
purposes of stock basis and E&P adjustments). Expansion of the rule is 
consistent in many respects with current Sec. 1.1502-32(k).
    Because the final regulations retain the proposed entitlement rule 
for all Federal income tax purposes, S's E&P is reduced at the time P 
becomes entitled to a distribution from S. Applying the entitlement 
rule for E&P purposes is consistent with its application for stock 
basis adjustments and is necessary to prevent distortions in the amount 
of S's E&P when S leaves the group.
    For example, assume that S has $50 of E&P from separate return 
years and $30 of current consolidated return year E&P. If S distributes 
$30 to P before becoming a nonmember, this distribution is treated as 
being made out of consolidated E&P. Thus, S's consolidated E&P is 
reduced to $0 and S continues to have $50 of accumulated E&P as a 
nonmember. Applying the entitlement rule for E&P purposes ensures 
consistent results for any distribution to which P becomes entitled 
while S is a member. Otherwise, S's $30 of consolidated E&P would be 
eliminated under the final regulations when S becomes a nonmember, and 
its $50 of accumulated E&P would be reduced by the amount of the 
distribution (to $20) due to a delay of the dividend payment until 
after S becomes a nonmember.
    In addition, the final regulations retain and clarify the current 
rules for making proper adjustments to E&P where the location of a 
member other than the common parent changes within the group.
c. Tax Sharing Agreements
    The current and the proposed regulations permit groups to elect to 
treat as a tax liability any amounts owing from one member to another 
as compensation for the absorption of tax attributes. The proposed 
regulations also require compensating amounts to be reflected for 
purposes of determining stock basis adjustments. In response to 
comments, the final regulations permit groups to conform the 
determination of E&P to the amounts reflected in stock basis.

9. Circular Basis Adjustments

    The ``circular basis'' provisions of the current regulations limit 
the use of S's deductions and losses to offset P's gain from the sale 
of S stock. Without these rules, the absorption of S's losses would 
reduce P's basis in S's stock under the stock basis adjustment rules 
and thereby correspondingly increase P's gain on the stock sale. 
Ultimately, S's losses could be completely absorbed without reducing 
the net amount of P's gain on the stock sale.
    The proposed regulations generally restate and clarify the current 
rule, and continue to prevent S's losses from offsetting P's gain from 
the sale of S stock. The proposed regulations expand the current rule 
to prevent losses of S's wholly owned subsidiary from offsetting P's 
gain from the sale of S stock, because absorption of these losses 
similarly reduces the basis of S's stock and correspondingly increases 
P's gain.
    Commentators suggested that the limitation be further expanded to 
include brother-sister cases. If P owns all of the stock of S1 and S2, 
the proposed regulations do not limit the use of S1's losses against 
P's gain from the sale of S2 stock or the use of S2's losses against 
P's gain from the sale of S1 stock. The final regulations do not extend 
the limitation because these cases cannot readily be distinguished from 
cases to which commentators believe the rules should not apply, and 
from cases in which some taxpayers would be disadvantaged.
    Assume that P owns the stock of S1 with a $100 basis and $100 
value, and the stock of S2 with a $100 basis and $150 value. S1 has a 
$20 NOL and S2's assets have a $100 basis. In Year 1, P sells S2's 
stock at a $50 gain, S1's NOL offsets $20 of P's gain, and use of the 
NOL reduces P's basis in S1 from $100 to $80. In Year 2, P sells S1 at 
an additional $20 gain. The group's aggregate gain in Years 1 and 2 is 
$50, and S's NOL is effectively eliminated.
    Although many commentators suggested that S1's NOL be limited if 
its stock is also sold in Year 1, none suggested that the NOL be 
limited if S1's stock is sold in a later year. In addition, none 
suggested that S1's NOL be limited in Year 1 if P causes S2 to sell its 
assets rather than selling the S2 stock.
    The suggested extension of the current limitation would be 
unfavorable to P if, for example, P had a $120 basis in S1's stock and 
the $20 loss inherent in the S1 stock could not be deducted under 
Sec. 1.1502-20. Extending the limitation would prevent the group from 
offsetting S1's NOL against S2's taxable income merely to preserve P's 
stock loss that will be disallowed.
    The final regulations retain the proposed rules.

10. Group Structure Change Rules

    The proposed regulations expand the rules of current temporary 
regulations for determining stock basis and E&P in certain group 
structure changes. For example, if P is the common parent and its 
shareholders form a holding company (H) by transferring their P stock 
to H in a transaction to which section 351 applies, the transaction is 
a group structure change and H's basis in the P stock is determined 
under the current regulations by reference to the net basis of P's 
assets (rather than the basis of P's former shareholders in their P 
stock). The proposed regulations expand the scope of the current rules 
by including group structure changes that involve recognition 
transactions and by requiring only a 50% continuity of shareholders 
(rather than 80%), because the existence of the group is preserved in 
these transactions.
    Commentators criticized the expansion of the current rules. Some 
argued that the rules should not be extended to taxable transactions 
because those transactions do not represent a mere rearrangement of the 
group's structure. However, the extension is consistent with the 
general approach of the current regulations to preserving the group's 
identity, and taxable transactions are indistinguishable for this 
purpose from nonrecognition transactions that were preceded by taxable 
transactions.
    Commentators also suggested that P's NOLs should be treated as 
additional basis in determining P's net asset basis. This approach was 
not followed in the proposed regulations because additional rules would 
have been required if an NOL could be duplicated in H's basis in P's 
stock (e.g., if the NOL is subject to limitation under section 382).
    The final regulations retain the approach of the proposed 
regulations but, in response to comments, allow the group to waive any 
loss carryovers of the former common parent immediately before the 
group structure change. The waiver is intended to permit groups to 
avoid later negative adjustments to H's basis in P's stock from the 
expiration of the loss carryovers.

11. Elimination of the 30-day Rules

    The proposed regulations (together with Notice 92-59) eliminate the 
30-day rules under the current regulations for corporations becoming or 
ceasing to be members on or after February 15, 1993. The 30-day rules 
were intended to be rules of administrative convenience. However, they 
create numerous inconsistencies that are not easily resolved, can lead 
to substantial complexity, and create unintended tax planning 
opportunities.
    Many problems are raised by the 30-day rules. The rules apply only 
for purposes of the consolidated return regulations and therefore may 
conflict with rules under the Code that rely on precise timing (e.g., 
the effective date of a statutory provision applicable to acquisitions, 
or the date of an ownership change under section 382 resulting from 
joining or leaving a group). The rules may result in anomalies (e.g., 
if an historic member liquidates within the first 30 days of the 
group's year, taxpayers may argue that the member could deconsolidate 
itself for the short year ending with the liquidation). The recast of 
the 30-day rules may conflict with other recasts under the Code (e.g., 
if P acquires S's stock in a section 338(g) transaction, accelerating 
the inclusion of S in the P group to before the qualified stock 
purchase is inconsistent with section 338 policy, which does not permit 
S's gain on the deemed asset sale to be included in the P group's 
return). The 30-day rules could affect the results of virtually any 
transaction between S and another member of the selling or buying group 
during the 30-day period (e.g., if S distributes a lower-tier member's 
stock to its parent before P's acquisition of S's stock, it is unclear 
whether the 30-day rules could cause S's distribution to be treated as 
made from the P group).
    Several alternatives were considered in developing the proposed 
regulations, but each alternative presented additional problems. It is 
not feasible to apply the 30-day rules uniformly under the Code because 
of the many conflicts that arise whenever the ownership of S's stock is 
treated as other than where the benefits and burdens of stock ownership 
reside. Accordingly, the final regulations continue the approach of the 
proposed regulations, but eliminate the 30-day rules only for 
subsidiaries that become or cease to be members of consolidated groups 
on or after January 1, 1995.
    To ameliorate the administrative burdens of eliminating the 30-day 
rules, the final regulations allow taxpayers to use new simplified 
rules for allocating items to the short period that the 30-day rules 
eliminate. The final regulations further simplify item allocations by 
permitting taxpayers to prorate a target's items for the month of its 
acquisition or disposition. Guidance is being considered that 
identifies circumstances in which a stock acquisition formally 
occurring on one date may be treated for all Federal income tax 
purposes as occurring as of another date, if the benefits and burdens 
of ownership are transferred on the other date.

12. Miscellaneous Changes

a. Intercompany Transaction Rules
    The final regulations move certain basis rules from Sec. 1.1502-31 
to the related provisions in Secs. 1.1502-13 and 1.1502-14. These 
changes were not included in the proposed regulations because they were 
to be more fully considered in connection with revisions to the 
intercompany transaction system. See CO-11-91, 59 FR 18011. No 
inference should be drawn from the relocation of these rules, which is 
now necessary because the proposed investment adjustment rules are 
being finalized before the proposed intercompany transaction rules.
b. Restoration of Excess Loss Accounts Due to Worthlessness
    The final regulations provide an additional restoration provision 
related to S's worthlessness. Under the additional rule, P's excess 
loss account with respect to S's stock is restored if any member takes 
into account a deduction or loss for the uncollectibility of debt of S 
and S does not take into account a corresponding amount of income or 
gain in determining consolidated taxable income.
c. Loss Disallowance
    The final regulations make technical changes in Sec. 1.1502-20. 
Most of these changes conform the rules to the revised investment 
adjustment system. For example, the final regulations remove 
Sec. 1.1502-20(e)(3) Example 8 because it is no longer necessary under 
the revised investment adjustment system. The final regulations also 
remove Sec. 1.1502-20(a)(5) Example 6(iii) because it incorrectly 
interprets Sec. 1.267(f)-2T. Consideration will be given to relief 
under section 7805(b) for taxpayers adversely affected by the changes.
    Commentators expressed concern that the statement of purposes set 
forth in the proposed investment adjustment rules had the effect of 
disallowing positive investment adjustments for S's built-in gains, so 
that its stock would be sold at an increased gain. The statement of 
purposes was not intended to have this effect and has been modified in 
the final regulations.
d. Amendments to the Basis Reduction Account
    The current regulations originally provided that, if S became a 
nonmember but P continued to own S stock, P's basis in the stock would 
be reduced before S became a nonmember. This rule was intended to 
eliminate the dividend stripping potential created because P's basis in 
S's stock increases for S's E&P during consolidated return years but 
generally does not decrease for S's distributions to P after S becomes 
a nonmember.
    Temporary consolidated return regulations were issued in 1988 to 
eliminate this adjustment. Under the temporary regulations, P's basis 
increases are not eliminated. Instead, P has a basis reduction account 
(BRA) in S's stock and reduces its basis in the stock to the extent P 
subsequently receives distributions from S not in excess of the BRA.
    The final regulations replace this system with a simpler approach. 
However, the BRA continues to apply (together with the other 
consequences of S becoming a nonmember) if S becomes a nonmember before 
the final regulations are effective.
    Commentators requested modifications to the BRA to eliminate 
anomalies. The proposed regulations did not modify the BRA because the 
approach of the proposed regulations to potential dividend stripping is 
inconsistent with the approach of the BRA, and the necessary 
corrections would have been complex and may have required amended 
returns for prior periods. For the same reasons, the final regulations 
do not amend the BRA rules for subsidiaries that ceased to be members 
before the final regulations are effective.
e. Becoming or Ceasing To Be a Member
    Under the proposed regulations, if S becomes or ceases to be a 
member during the group's tax year, the periods ending and beginning 
with S's becoming or ceasing to be a member are separate tax years for 
all Federal income tax purposes. However, the proposed regulations 
provide an election for allocating S's nonextraordinary items of 
income, gain, deduction, loss, and credit between the group's year and 
S's separate return year. For this purpose, the proposed regulations 
identify extraordinary items that are not subject to this ratable 
allocation.
    The final regulations continue the approach of the proposed 
regulations and, in response to comments, the list of extraordinary 
items not subject to the ratable allocation election is expanded. In 
response to comments, the final regulations also allow S's 
nonextraordinary items from the month that S becomes or ceases to be a 
member to be allocated ratably within the month.
    The proposed regulations provide that S generally becomes a member 
or ceases to be a member at the end of the day on which its status as a 
member changes (rather than at a specific time during the day). In 
response to comments, the final regulations provide that transactions 
occurring on the day of the change, but after the event that results in 
the change, are treated as occurring at the beginning of the following 
day if they are properly allocable to the part of the day after the 
event.
f. Distributions
    Under Sec. 1.1502-14 of the current regulations, P recognizes no 
gain with respect to a distribution from S that is described in section 
301(c)(3); instead, such a distribution contributes to an excess loss 
account in S's stock. The proposed intercompany transaction regulations 
fully address the treatment of these distributions and continue the 
treatment provided under current law. See CO-11-91, 59 FR 18011. 
Consequently, the proposed amendment to Sec. 1.1502-80 providing for 
the nonapplicability of section 301(c)(3) is unnecessary and is not 
retained in these final regulations. The treatment under current law is 
therefore retained.
    The final regulations also clarify that the negative stock basis 
adjustment for distributions applies to all amounts to which section 
301 applies and all other amounts treated as dividends (e.g., under 
section 356(a)(2)).

13. Effective Dates

a. Disposition Approach
    The final regulations generally apply to determinations and 
transactions in tax years beginning on or after January 1, 1995. Once 
the final regulations apply, stock basis and E&P are determined or 
redetermined as if the regulations had always been in effect. However, 
the final regulations are not taken into account for tax years 
beginning before January 1, 1995.
    Among the reasons for adopting the disposition approach are: (i) it 
eliminates the need to perpetuate prior regulations to determine prior 
period adjustments (including the need for E&P studies required to make 
the determinations); (ii) it eliminates the need for transitional rules 
to prevent duplication or omission of items under the pre-1966, 
current, and final regulations; (iii) it incorporates the principles of 
section 1503(e)(1)(A), which would otherwise require stock basis 
modifications for periods since 1972; and (iv) it eliminates anomalies 
arising from the adoption in 1966 of the first complete stock basis 
adjustment system (e.g., the inability to reflect pre-1966 E&P in stock 
basis if the E&P is lost before a deemed dividend election).
    The most frequently discussed alternative to the disposition 
approach is a ``lock-in'' approach, under which the new rules would 
apply only to adjustments arising after the effective date of the final 
regulations. Several commentators suggested using a lock-in approach, 
or a combination of approaches (e.g., permitting a group to apply the 
current rules for adjustments in prior years, provided S is sold within 
the next 3 to 5 years). Commentators cited concerns with the 
administrative burdens of recomputing prior period adjustments, 
preserving taxpayer expectations, and determining pre-1966 adjustments.
    Many taxpayers will benefit from the elimination of anomalies under 
the new regulations, and some commentators requested an earlier 
effective date, at least on an elective basis (e.g., for determinations 
between the date the regulations were proposed and the date they are 
finalized).
    Although a lock-in approach would avoid requiring groups to apply 
the new rules to prior period adjustments, and may protect taxpayer 
expectations, the IRS and the Treasury Department understand that few 
groups determine their stock basis adjustments annually and therefore 
have any substantial expectation regarding stock basis before a stock 
disposition is contemplated. A lock-in approach cannot be applied 
without complex rules to prevent the duplication or omission of items 
that would result from inconsistencies between the current and proposed 
regulations. The lock-in approach is therefore inconsistent with the 
simplified general approach of the regulations. The final regulations 
retain the disposition approach of the proposed regulations.
    The proposed regulations would have applied to basis determinations 
after the date of adoption of the final regulations. To give taxpayers 
advance notice of the final rules, and to avoid complexities from 
applying both the current and the final regulations in a single tax 
year, the final regulations apply to determinations in tax years 
beginning on or after January 1, 1995. For prior years for which 
information is incomplete (e.g., pre-1966 years), taxpayers should use 
reasonable methods to comply with the final regulations, based on 
available information, including income tax returns, financial 
statements and statements of retained earnings.
b. Elimination of the 30-day Rules
    The proposed regulations, together with Notice 92-59, would have 
eliminated the 30-day rules effective February 15, 1993. In response to 
comments, the final regulations eliminate the 30-day rules for 
subsidiaries that become or cease to be members on or after January 1, 
1995.

14. Commissioner's Permission To Deconsolidate

    The current regulations generally authorize the Commissioner to 
grant all groups, or groups in a particular class, permission to 
discontinue filing consolidated returns if any provision of the Code or 
regulations has been amended and the amendment could have a substantial 
adverse effect.
    Some commentators suggested that the proposed regulations warranted 
granting permission to deconsolidate because the effective date of the 
regulations is based on a disposition approach. Although permission to 
deconsolidate is rarely granted, guidance is anticipated to be issued 
on or before December 31, 1994, pursuant to which groups may receive 
permission to deconsolidate for their first taxable year beginning on 
or after January 1, 1995. Permission for a group to deconsolidate will 
only be granted, however, on a showing that the net effect of the final 
regulations on the group's consolidated tax liability is substantially 
adverse.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations, and, therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Small Business Administration for comment on its 
impact on small business.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR Parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for Part 1 is amended by 
removing the entries for sections ``1.1502-19'', ``1.1502-32(k)'', 
``1.1502-32T'', and ``1.1502-80'' and adding the following citations to 
read as follows:

    Authority: 26 U.S.C. 7805 * * * Section 1.1502-11 also issued 
under 26 U.S.C. 1502. * * * Section 1.1502-19 also issued under 26 
U.S.C. 301, 1502, and 1503. * * * Section 1.1502-31 also issued 
under 26 U.S.C. 1502. * * * Section 1.1502-32 also issued under 26 
U.S.C. 301, 1502, and 1503. Section 1.1502-33 also issued under 26 
U.S.C. 301, 1502, and 1503. * * * Section 1.1502-76 also issued 
under 26 U.S.C. 1502. * * * Section 1.1502-80 also issued under 26 
U.S.C. 165, 304, and 1502. * * *

    Par. 2. In the list below, for each location indicated in the left 
column, remove the language in the middle column, and add the language 
in the right column in its place. 

----------------------------------------------------------------------------------------------------------------
           Affected section                             Remove                                Add               
----------------------------------------------------------------------------------------------------------------
1.167(c)-1(a)(5)......................  ``and 1.1502-31''....................  ``, 1.1502-13, and 1.1502-14''   
1.337(d)-1(a)(5) introductory text....  ``Secs. 1.1502-32 and 1.1502-33(c)''.  ``Sec. 1.1502-32''               
1.337(d)-2(c)(4) Example..............  Secs. 1.1502-32 and 1.1502-33(c)''...  ``Sec. 1.1502-32''               
1.469-1T(h)(7)........................  ``1.1502-19(a)''.....................  ``1.1502-19''                    
1.1502-13(j) introductory text........  ``, 1.1502-31,''.....................  .................................
1.1502-13(l)(2), Example (1)(i).......  ``under Sec. 1.1502-31(a)''..........  .................................
1.1502-13(m)(3), Example (3)(i).......  ``Under Sec. 1.1502-31(a),''.........  .................................
1.1502-13(o)(1)(i)....................  ``1.1502-19(b)(2)''..................  ``1.1502-19(c)(1) (ii) or (iii)''
1.1502-13(o)(1)(ii)...................  ``1.1502-19(b)(2)''..................  ``1.1502-19(c)(1) (ii) or (iii)''
1.1502-13(o)(2), Example (i)..........  ``under Sec. 1.1502-31(a)''..........  .................................
1.1502-13(o)(2), Example (iii)........  ``1.1502-19(b)(2)(i)''...............  ``1.1502-19''                    
1.1502-14(b)(3)(ii)...................  ``1.1502-19(b)(2) (other than          ``1.1502-19(c)(1)(ii)(B) or      
                                         subdivision (ii) thereof)''.           (iii)''                         
1.1502-14(d)(3)(ii)...................  ``1.1502-19(b)(2) (other than          ``1.1502-19(c)(1)(ii)(B) or      
                                         subdivision (ii) thereof)''.           (iii)''                         
1.1502-14(d)(4)(ii)(b)................  ``1.1502-19(b)(2) (other than          ``1.1502-19(c)(1)(ii)(B) or      
                                         subdivision (ii) thereof),             (iii)''                         
                                         determined without regard to Sec.                                      
                                         1.1502-19(d) and (e)''.                                                
1.1502-14(g)(1)(i)....................  ``1.1502-19(b)(2)''..................  ``1.1502-19(c)(1) (ii) or (iii)''
1.1502-14(g)(1)(ii)...................  ``1.1502-19(b)(2)''..................  ``1.1502-19(c)(1) (ii) or (iii)''
1.1502-14(g)(2), Example 1(ii)........  ``1.1502-19(b)(2)(i)''...............  ``1.1502-19''                    
1.1502-43(a)(3)(ii)...................  ``1.1502-33(c)(4)(ii)''..............  ``1.1502-33(b)''                 
1.1502-43(a)(3)(iii)..................  ``1.1502-33(c)(4)(i)(b)''............  ``1.1502-33(c)(1)''              
1.1502-47(e)(4)(iii)(B)...............  ``1.1502-19(b)(2)(vi)''..............  ``1.1502-19(c)''                 
1.1502-75(d)(5)(viii).................  ``1.1502-32(b)(2)(iii)(c) and          ``1.1502-32(h)(5)''              
                                         (c)(2)(iii)''.                                                         
1.1502-81T(a).........................  ``1.1502-32(b)(1)''..................  ``1.1502-32(b)''                 
1.1552-1(c)(2)........................  ``paragraph (d)(3) of''..............  .................................
----------------------------------------------------------------------------------------------------------------


    Par. 3. Section 1.279-6 is amended by revising paragraph (b)(4) to 
read as follows:


Sec. 1.279-6  Application of section 279 to certain affiliated groups.

* * * * *
    (b) * * *
    (4) The basis of property in a transaction to which Sec. 1.1502-13, 
Sec. 1.1502-13T, Sec. 1.1502-14, or Sec. 1.1502-14T applies is the 
basis of the property determined under that section; and
* * * * *
    Par. 4. Section 1.337(d)-1, paragraph (a)(5) is amended by removing 
paragraph (iii) of Example 8.
    Par. 5. Section 1.1502-1 is amended by adding at the end of 
paragraph (a) a new sentence to read as follows:


Sec. 1.1502-1  Definitions.

    (a) * * * Except as the context otherwise requires, references to a 
group are references to a consolidated group (as defined in paragraph 
(h) of this section).
* * * * *
    Par. 6. Section 1.1502-11 is amended by revising paragraph (b) to 
read as follows:


Sec. 1.1502-11  Consolidated taxable income.

* * * * *
    (b) Elimination of circular stock basis adjustments--(1) In 
general. If one member (P) disposes of the stock of another member (S), 
this paragraph (b) limits the use of S's deductions and losses in the 
year of disposition and the carryback of items to prior years. The 
purpose of the limitation is to prevent P's income or gain from the 
disposition of S's stock from increasing the absorption of S's 
deductions and losses, because the increased absorption would reduce 
P's basis (or increase its excess loss account) in S's stock under 
Sec. 1.1502-32 and, in turn, increase P's income or gain. See paragraph 
(b)(3) of this section for the application of these principles to P's 
deduction or loss from the disposition of S's stock, and paragraph 
(b)(4) of this section for the application of these principles to 
multiple stock dispositions. See Sec. 1.1502-19(c) for the definition 
of disposition.
    (2) Limitation on deductions and losses--(i) Determination of 
amount of limitation. If P disposes of one or more shares of S's stock, 
the extent to which S's deductions and losses for the tax year of the 
disposition (and its deductions and losses carried over from prior 
years) may offset income and gain is subject to limitation. The amount 
of S's deductions and losses that may offset income and gain is 
determined by tentatively computing taxable income (or loss) for the 
year of disposition (and any prior years to which the deductions or 
losses may be carried) without taking into account P's income and gain 
from the disposition.
    (ii) Application of limitation. S's deductions and losses offset 
income and gain only to the extent of the amount determined under 
paragraph (b)(2)(i) of this section. To the extent S's deductions and 
losses in the year of disposition cannot offset income or gain because 
of the limitation under this paragraph (b), the items are carried to 
other years under the applicable provisions of the Internal Revenue 
Code and regulations as if they were the only items incurred by S in 
the year of disposition. For example, to the extent S incurs an 
operating loss in the year of disposition that is limited, the loss is 
treated as a separate net operating loss attributable to S arising in 
that year. The tentative computation does not affect the manner in 
which S's unlimited deductions and losses are absorbed or the manner in 
which deductions and losses of other members are absorbed. (If the 
amount of S's unlimited deductions and losses actually absorbed is less 
than the amount absorbed in the tentative computation, P's stock basis 
adjustments under Sec. 1.1502-32 reflect only the amounts actually 
absorbed.)
    (iii) Examples. For purposes of the examples in this paragraph (b), 
unless otherwise stated, P owns all of the only class of S's stock for 
the entire year, S owns no stock of lower-tier members, the tax year of 
all persons is the calendar year, all persons use the accrual method of 
accounting, the facts set forth the only corporate activity, all 
transactions are between unrelated persons, and tax liabilities are 
disregarded. The principles of this paragraph (b)(2) are illustrated by 
the following examples.

    Example 1. Limitation on losses with respect to stock gain. (a) 
P has a $500 basis in S's stock. For Year 1, P has ordinary income 
of $30 (determined without taking P's gain or loss from the 
disposition of S's stock into account) and S has an $80 ordinary 
loss. P sells S's stock for $520 at the close of Year 1.
    (b) To determine the amount of the limitation on S's loss under 
paragraph (b)(2)(i) of this section, and the effect under 
Sec. 1.1502-32(b) of the absorption of S's loss on P's basis in S's 
stock, P's gain or loss from the disposition of S's stock is not 
taken into account. The group is tentatively treated as having a 
consolidated net operating loss of $50 (P's $30 of income minus S's 
$80 loss). Thus, $50 of S's loss is limited under this paragraph 
(b).
    (c) Because $30 of S's loss is absorbed in the determination of 
consolidated taxable income under paragraph (b)(2)(ii) of this 
section, P's basis in S's stock is reduced under Sec. 1.1502-32(b) 
from $500 to $470 immediately before the disposition. Consequently, 
P recognizes a $50 gain from the sale of S's stock and the group has 
consolidated taxable income of $50 for Year 1 (P's $30 of ordinary 
income and $50 gain from the sale of S's stock, less the $30 of S's 
loss). In addition, S's limited loss of $50 is treated as a separate 
net operating loss attributable to S and, because S ceases to be a 
member, the loss is apportioned to S under Sec. 1.1502-79 and 
carried to its first separate return year.
    Example 2. Carrybacks and carryovers. (a) For Year 1, the P 
group has consolidated taxable income of $30, and a consolidated net 
capital loss of $100 ($50 attributable to P and $50 to S). At the 
beginning of Year 2, P has a $300 basis in S's stock. For Year 2, P 
has ordinary income of $30, and a $20 capital gain (determined 
without taking the $100 consolidated net capital loss carryover or 
P's gain or loss from the disposition of S's stock into account), 
and S has a $100 ordinary loss. P sells S's stock for $280 at the 
close of Year 2.
    (b) To determine the amount of the limitation under paragraph 
(b)(2)(i) of this section on S's losses, and the effect of the 
absorption of S's losses on P's basis in S's stock under 
Sec. 1.1502-32(b), P's gain or loss from the disposition of S's 
stock is not taken into account. For Year 2, the P group is 
tentatively treated as having a $70 consolidated net operating loss 
(S's $100 ordinary loss, less P's $30 of ordinary income). The P 
group is also treated as having no consolidated net capital gain in 
Year 2, because P's $20 capital gain is reduced by $20 of the 
consolidated net capital loss carryover from Year 1 under section 
1212(a) (the absorption of which is attributed equally to P and S). 
In addition, of the $70 consolidated net operating loss, $30 is 
carried back to Year 1 and offsets P's ordinary income in that year, 
and $40 is carried forward. Consequently, $40 of S's operating loss 
from Year 2, and $40 of the consolidated net capital loss carryover 
from Year 1 attributable to S, are limited under this paragraph (b).
    (c) Under paragraph (b)(2)(ii) of this section, the limitation 
under this paragraph (b) does not affect the absorption of any 
deductions and losses attributable to P, $60 of S's operating loss 
from Year 2, and $10 of the consolidated net capital loss from Year 
1 attributable to S. Consequently, P's basis in S's stock is reduced 
under Sec. 1.1502-32(b) by $70, from $300 to $230, and P recognizes 
a $50 gain from the sale of S's stock in Year 2. Thus, the P group 
is treated as having a $20 unlimited net operating loss that is 
carried back to Year 1: 

Ordinary income:                                                        
  P...........................................................      $30 
  S (excluding the $40 limited loss)..........................      (60)
                                                               ---------
    Sub Total.................................................     $(30)
Consolidated net capital gain:                                          
  P ($20 + $50 from S stock - $50 from Year 1)................      $20 
  S (-$10 from Year 1)........................................      (10)
                                                               ---------
    Sub Total.................................................      $10 
Consolidated taxable income...................................     $(20)
                                                                        


    (d) Under paragraph (b)(2)(ii) of this section, S's $40 ordinary 
loss from Year 2 that is limited under this paragraph (b) is treated 
as a separate net operating loss arising in Year 2. Similarly, $40 
of the consolidated net capital loss from Year 1 attributable to S 
is treated as a separate net capital loss carried over from Year 1. 
Because S ceases to be a member, the $40 net operating loss from 
Year 2 and the $40 consolidated net capital loss from Year 1 are 
allocated to S under Sec. 1.1502-79 and are carried to S's first 
separate return year.
    Example 3. Allocation of basis adjustments. (a) For Year 1, the 
P group has consolidated taxable income of $100. At the beginning of 
Year 2, P has a $40 basis in each of the 10 shares of S's stock. For 
Year 2, P has an $80 ordinary loss (determined without taking into 
account P's gain or loss from the disposition of S's stock) and S 
has an $80 ordinary loss. P sells 2 shares of S's stock for $85 each 
at the close of Year 2.
    (b) Under paragraph (b)(2)(i) of this section, the amount of the 
limitation on S's loss is determined by tentatively treating the P 
group as having a $160 consolidated net operating loss for Year 2. 
Of this amount, $100 is carried back under section 172 and absorbed 
in Year 1 ($50 attributable to S and $50 attributable to P). 
Consequently, $30 of S's loss is limited under this paragraph (b).
    (c) Under paragraph (b)(2)(ii) of this section, the limitation 
under this paragraph (b) does not affect the absorption of P's $80 
ordinary loss or $50 of S's ordinary loss. Consequently, P's basis 
in each share of S's stock is reduced from $40 to $35 under 
Sec. 1.1502-32(b), and P recognizes a $100 gain from the sale of the 
2 shares. Thus, the P group is treated as having a $30 unlimited net 
operating loss: 

Ordinary loss:                                                          
  P...........................................................     $(80)
  S (excluding the $30 limited loss)..........................      (50)
                                                               ---------
    Sub Total.................................................    $(130)
Consolidated net capital gain:                                          
  P...........................................................     $100 
  S...........................................................        0 
                                                               ---------
    Sub Total.................................................     $100 
Unlimited consolidated net operating loss.....................     $(30) 
                                                                        

    (d) A portion of the $130 of unlimited operating losses for Year 
2 is fully absorbed in that year, and a portion is carried back to 
Year 1. Thus, $61.50 of P's $80 loss ($100 multiplied by $80/$130) 
and $38.50 of S's $50 unlimited loss ($100 multiplied by $50/$130) 
are absorbed in Year 2. P's remaining $18.50 of loss and S's 
remaining $11.50 of loss are not subject to limitation and are 
carried back and absorbed in Year 1.
    (e) Under paragraph (b)(2)(ii) of this section, S's $30 of loss 
limited under this paragraph (b) is treated as a separate net 
operating loss and, because S ceases to be a member, the loss is 
apportioned to S under Sec. 1.1502-79 and carried to its first 
separate return year.
    (3) Loss dispositions--(i) General rule. The principles of 
paragraph (b)(2) of this section apply to the extent necessary to 
carry out the purposes of paragraph (b)(1) of this section if P 
recognizes a deduction or loss from the disposition of S's stock.
    (ii) Example. The principles of this paragraph (b)(3) are 
illustrated by the following example.
    Example. (a) P has a $400 basis in S's stock. For Year 1, P has 
a capital gain of $100 (determined without taking P's gain or loss 
from the disposition of S's stock into account) and S has both a $60 
capital loss and a $200 ordinary loss. P sells S's stock for $140 at 
the close of Year 1.
    (b) Under paragraph (b)(3) of this section, the amount of S's 
ordinary and capital losses that may offset income and gain is 
determined by tentatively computing the group's consolidated net 
operating loss and consolidated net capital loss without taking into 
account P's loss from the disposition of S's stock. The limitation 
is necessary to prevent P's loss from the disposition of S's stock 
from affecting the absorption of S's losses and thereby the 
adjustments to P's basis in S's stock under Sec. 1.1502-32(b) (which 
would, in turn, affect P's loss).
    (c) Under the principles of paragraph (b)(2)(i) of this section, 
the amount of the limitation on S's loss is determined by 
tentatively treating the P group as having a $40 consolidated net 
capital gain and a $200 ordinary loss, which results in a $160 
consolidated net operating loss for Year 1, all of which is 
attributable to S. Thus, $160 of S's ordinary loss is limited under 
this paragraph (b). See also Sec. 1.1502-20 for rules applicable to 
losses from the sale of stock of subsidiaries.

    (4) Multiple dispositions--(i) Stock of a member. To the extent 
income, gain, deduction, or loss from a prior disposition of S's stock 
is deferred under any rule of law, the limitation under paragraph 
(b)(2) of this section is determined by treating the year the deferred 
amount is taken into account as the year of the disposition.
    (ii) Stock of different members. If S is a higher-tier corporation 
with respect to another member (T), and all of T's items of income, 
gain, deduction, and loss (including the absorption of T's deduction or 
loss) would be fully reflected in P's basis in S's stock under 
Sec. 1.1502-32, the limitation under paragraph (b)(2)(i) of this 
section with respect to T's deductions and losses is determined without 
taking into account any income, gain, deduction, or loss from the 
disposition of the stock of S or T (or of the stock of members owned in 
the chain connecting S and T). However, this paragraph (b) does not 
otherwise limit the absorption of one member's deduction or loss with 
respect to the disposition of another member's stock.
    (iii) Examples. The principles of this paragraph (b)(4) are 
illustrated by the following examples.

    Example 1. Chain of subsidiaries. (a) P owns all of S's stock 
with a $500 basis, and S owns all of T's stock with a $500 basis. 
For Year 1, P has ordinary income of $30, S has no income or loss, 
and T has an $80 ordinary loss. P sells S's stock for $520 at the 
close of Year 1.
    (b) Under paragraph (b)(4) of this section, to determine the 
amount of the limitation under paragraph (b) of this section on T's 
loss, and the effect of the absorption of T's loss on P's basis in 
S's stock under Sec. 1.1502-32(b), P's gain or loss from the 
disposition of S's stock is not taken into account. The group is 
tentatively treated as having a consolidated net operating loss of 
$50 (P's $30 of income minus T's $80 loss). Because only $30 of T's 
loss offsets income or gain, P's basis in S's stock is reduced under 
Sec. 1.1502-32(b) from $500 to $470 immediately before the 
disposition of S's stock. Thus, P takes into account a $50 gain from 
the sale of S's stock.
    (c) The facts are the same as in paragraph (a) of this Example 
1, except that S has a $10 excess loss account in T's stock (rather 
than a $500 basis). Under paragraph (b)(4) of this section, neither 
P's gain or loss from the disposition of S's stock nor S's gain or 
loss from the disposition of T's stock (under Sec. 1.1502-19) are 
taken into account for purposes of the tentative computations and 
the effect of any absorption under Sec. 1.1502-32(b) on P's basis in 
S's stock and S's excess loss account in T's stock. The group is 
tentatively treated as having a consolidated net operating loss of 
$50 (P's $30 of income minus T's $80 loss), and only $30 of T's loss 
may offset the group's income or gain. Under Sec. 1.1502-32(b), the 
absorption of $30 of T's loss increases S's excess loss account in 
T's stock to $40 and, under Sec. 1.1502-19, the excess loss account 
is taken into account. Moreover, under Sec. 1.1502-32(b), P's basis 
in S's stock is increased immediately before the sale by $10 (S's 
$40 gain under Sec. 1.1502-19(b) minus T's $30 loss absorbed and 
tiered up under Sec. 1.1502-32(b)), from $500 to $510. Thus, P takes 
into account a $10 gain from the sale of S's stock, and S takes into 
account a $40 gain from its excess loss account in T's stock.
    Example 2. Brother-sister subsidiaries. (a) P owns all of the 
stock of S1 and S2, each with a $50 basis. For Year 1, the group has 
a $100 consolidated net operating loss ($50 of which is attributable 
to S1, and $50 to S2) determined without taking gain or loss from 
the disposition of member stock into account. At the close of Year 
1, P sells the stock of S1 and S2 for $100 each.
    (b) Paragraph (b)(4) of this section does not limit the loss of 
S1 or S2 with respect to the disposition of stock of the other. 
Consequently, each subsidiary's loss may offset P's gain from the 
disposition of the stock of the other subsidiary. Because this 
absorption results in a $50 reduction in P's basis in the stock of 
each subsidiary under Sec. 1.1502-32(b), P's aggregate gain from the 
stock dispositions is increased from $100 to $200, $100 of which is 
offset by the losses of the subsidiaries.

    (5) Effective date. This paragraph (b) applies to stock 
dispositions occurring in consolidated return years beginning on or 
after January 1, 1995. For prior years, see Sec. 1.1502-11(b) as 
contained in the 26 CFR part 1 edition revised as of April 1, 1994.
    Par. 7. Section 1.1502-13 is amended as follows:
    1. In paragraph (c)(1)(iii), the second sentence is removed.
    2. Paragraph (c)(7) is redesignated as paragraph (c)(8).
    3. New paragraph (c)(7) is added.
    4. In paragraph (h), Example (17)(ii) is revised.
    5. The added and revised provisions read as follows:


Sec. 1.1502-13  Intercompany transactions.

* * * * *
    (c) * * *
    (7) Basis. The basis of property acquired by a purchasing member in 
a deferred intercompany transaction is determined as if separate 
returns were filed. For example, if S owns property with an adjusted 
basis of $80 and sells it to P for $100 in a deferred intercompany 
transaction, P's basis in the property is $100 even though S defers its 
$20 gain on the sale under this paragraph (c).
* * * * *
    (h) * * *

    Example (17). * * *
    (ii) P takes the entire $44,000 gain ($104,000 less $60,000) on 
the land into account for 1966 since the deferral and basis rules 
provided in paragraph (c) of this section were not effective with 
respect to the sale of such land.
* * * * *
    Par. 8. Section 1.1502-14 is amended as follows:
    1. Paragraph (a)(2) is revised.
    2. Paragraph (a)(4) is redesignated as paragraph (a)(6).
    3. New paragraph (a)(4) is added.
    4. Paragraph (a)(5) is revised.
    5. In newly designated paragraph (a)(6), the Example is amended by 
revising the last sentence.
    6. New paragraph (b)(4) is added.
    7. The revised and added provisions read as follows:


Sec. 1.1502-14  Stock, bonds, and other obligations of members.

    (a) * * *
    (2) Nondividend distributions. No gain is recognized to the 
distributee on a distribution with respect to stock, from one member to 
another member during a consolidated return year, which is described in 
section 301(c) (2) or (3). See Secs. 1.1502-19 and 1.1502-32 for 
adjustments to stock basis (including negative adjustments in excess of 
basis).
* * * * *
    (4) Basis of property distributed in kind. The basis of property 
received in a distribution to which section 301 applies is determined 
under section 301(d)(2)(B).
    (5) Entitlement rule--(i) In general. This paragraph (a)(5)(i) 
applies for consolidated return years beginning on or after January 1, 
1995. For all Federal income tax purposes, a distribution to which this 
paragraph (a) applies is treated as taken into account when the 
shareholding member becomes entitled to it (generally on the record 
date). For example, if the distributee member becomes entitled to a 
cash distribution before it is made, the distribution is treated as 
made when the distributee member becomes entitled to it. For this 
purpose, stock is treated as entitled to a distribution no later than 
the time the distribution is taken into account under the Code (e.g., 
under section 305). Appropriate adjustments must be made, as of the 
date the distribution was taken into account, if a distribution is not 
made.
    (ii) Minority shareholders. If nonmembers own stock of the 
distributing corporation at the time the distribution is treated as 
occurring under paragraph (a)(5)(i) of this section, appropriate 
adjustments must be made to prevent acceleration of the members' 
portion of the distribution from affecting the earnings and profits 
consequences of distributions to nonmembers.
    (iii) Prior period distributions. For rules relating to 
distributions before paragraph (a)(5)(i) of this section applies, see 
Secs. 1.1502-14(a) (intercompany distributions generally) and 1.1502-
32(k) (distributions declared before, but paid after, a stock 
disposition) as contained in the 26 CFR part 1 edition revised as of 
April 1, 1994.
    (6) * * *
    Example. * * * P's basis in the land is $6,000.
* * * * *
    (b) * * *
    (4) Basis after liquidation or distribution. The basis of property 
acquired in a transaction to which this paragraph (b) applies is 
determined as follows:
    (i) Section 332. The basis of property acquired in a liquidation to 
which section 332 applies is determined as if separate returns were 
filed.
    (ii) Other liquidations and distributions. This paragraph 
(b)(4)(ii) determines the aggregate basis of all property acquired in a 
distribution in cancellation or redemption of stock to which paragraph 
(b)(1) of this section applies, other than a liquidation to which 
section 332 applies. Once the amount of aggregate basis is determined, 
it is allocated among the assets received (except cash) in proportion 
to the fair market values of the assets on the date received. The 
aggregate amount of basis equals--
    (A) The adjusted basis of the stock exchanged therefor (determined 
after taking into account the adjustments under Sec. 1.1502-32); 
increased by
    (B) The amount of any liabilities of the distributing corporation 
assumed by the distributee or to which the property acquired is 
subject; reduced by
    (C) The amount of cash received in the distribution.
* * * * *
    Par. 9. Section 1.1502-19 is revised to read as follows:


Sec. 1.1502-19  Excess loss accounts.

    (a) In general--(1) Purpose. This section provides rules for a 
member (P) to include in income its excess loss account in the stock of 
another member (S). The purpose of the excess loss account is to 
recapture in consolidated taxable income P's negative adjustments with 
respect to S's stock (e.g., under Sec. 1.1502-32 from S's deductions, 
losses, and distributions), to the extent the negative adjustments 
exceed P's basis in the stock.
    (2) Excess loss accounts--(i) In general. P's basis in S's stock is 
adjusted under the consolidated return regulations and other rules of 
law. Negative adjustments may exceed P's basis in S's stock. The 
resulting negative amount is P's excess loss account in S's stock. For 
example:
    (A) Once P's negative adjustments under Sec. 1.1502-32 exceed its 
basis in S's stock, the excess is P's excess loss account in the S 
stock. If P has further adjustments, they first increase or decrease 
the excess loss account.
    (B) If P forms S by transferring property subject to liabilities in 
excess of basis, Sec. 1.1502-80(d) provides for the nonapplicability of 
section 357(c) and the resulting negative basis under section 358 is 
P's excess loss account in the S stock.
    (ii) Treatment as negative basis. P's excess loss account is 
treated for all Federal income tax purposes as basis that is a negative 
amount, and a reference to P's basis in S's stock includes a reference 
to P's excess loss account.
    (3) Application of other rules of law. The rules of this section 
are in addition to other rules of law. See, e.g., Secs. 1.1502-32 
(investment adjustment rules establishing and adjusting excess loss 
accounts) and 1.1502-80(d) (nonapplicability of section 357(c)). The 
provisions of this section and other rules of law must not be applied 
to recapture the same amount more than once. For purposes of this 
section, the definitions in Sec. 1.1502-32 apply.
    (b) Excess loss account taken into account as income or gain--(1) 
General rule. If P is treated under this section as disposing of a 
share of S's stock, P takes into account its excess loss account in the 
share as income or gain from the disposition. Except as provided in 
paragraph (b)(4) of this section, the disposition is treated as a sale 
or exchange for purposes of determining the character of the income or 
gain.
    (2) Nonrecognition or deferral--(i) In general. P's income or gain 
under paragraph (b)(1) of this section is subject to any nonrecognition 
or deferral rules applicable to the disposition. For example, if S 
liquidates and the exchange of P's stock in S is subject to section 
332, or P transfers all of its assets (including S's stock) to S in a 
reorganization to which section 361(a) applies, P's income or gain from 
the excess loss account is not recognized under these rules.
    (ii) Nonrecognition or deferral inapplicable. If P's income or gain 
under paragraph (b)(1) of this section is from a disposition described 
in paragraph (c)(1) (ii) or (iii) of this section (relating to 
deconsolidations and worthlessness), the income or gain is taken into 
account notwithstanding any nonrecognition or deferral rules (even if 
the disposition is also described in paragraph (c)(1)(i) of this 
section). For example, if P transfers S's stock to a nonmember in a 
transaction to which section 351 applies, P's income or gain from the 
excess loss account is taken into account.
    (3) Tiering up in chains. If the stock of more than one subsidiary 
is disposed of in the same transaction, the income or gain under this 
section is taken into account in the order of the tiers, from the 
lowest to the highest.
    (4) Insolvency--(i) In general. Gain under this section is treated 
as ordinary income to the extent of the amount by which S is insolvent 
(within the meaning of section 108(d)(3)) immediately before the 
disposition. For this purpose S's liabilities include any amount to 
which preferred stock would be entitled if S were liquidated 
immediately before the disposition, and any former liabilities that 
were discharged to the extent the discharge was treated as tax-exempt 
income under Sec. 1.1502-32(b)(3)(ii)(C) (special rule for discharges).
    (ii) Reduction for amount of distributions. The amount treated as 
ordinary income under this paragraph (b)(4) is reduced to the extent it 
exceeds the amount of P's excess loss account redetermined without 
taking into account S's distributions to P to which Sec. 1.1502-
32(b)(2)(iv) applies.
    (c) Disposition of stock. For purposes of this section:
    (1) In general. P is treated as disposing of a share of S's stock:
    (i) Transfer, cancellation, etc. At the time--
    (A) P transfers or otherwise ceases to own the share for Federal 
income tax purposes, even if no gain or loss is taken into account; or
    (B) P takes into account gain or loss (in whole or in part) with 
respect to the share.
    (ii) Deconsolidation. At the time--
    (A) P becomes a nonmember, or a nonmember determines its basis in 
the share (or any other asset) by reference to P's basis in the share, 
directly or indirectly, in whole or in part (e.g., under section 362); 
or
    (B) S becomes a nonmember, or P's basis in the share is reflected, 
directly or indirectly, in whole or in part, in the basis of any asset 
other than member stock (e.g., under section 1071).
    (iii) Worthlessness. At the time--
    (A) Substantially all of S's assets are treated as disposed of, 
abandoned, or destroyed for Federal income tax purposes (e.g., under 
section 165(a) or Sec. 1.1502-80(c), or, if S's asset is stock of a 
lower-tier member, the stock is treated as disposed of under this 
paragraph (c)). An asset of S is not considered to be disposed of or 
abandoned to the extent the disposition is in complete liquidation of S 
or is in exchange for consideration;
    (B) An indebtedness of S is discharged, if any part of the amount 
discharged is not included in gross income and is not treated as tax-
exempt income under Sec. 1.1502-32(b)(3)(ii)(C); or
    (C) A member takes into account a deduction or loss for the 
uncollectibility of an indebtedness of S, and the deduction or loss is 
not matched in the same tax year by S's taking into account a 
corresponding amount of income or gain from the indebtedness in 
determining consolidated taxable income.
    (2) Becoming a nonmember. A member is treated as becoming a 
nonmember if it has a separate return year (including another group's 
consolidated return year). For example, S may become a nonmember if it 
issues additional stock to nonmembers, but S does not become a 
nonmember as a result of its complete liquidation. A disposition under 
paragraph (c)(1)(ii) of this section must be taken into account in the 
consolidated return of the group. For example, if a group ceases under 
Sec. 1.1502-75(c) to file a consolidated return as of the close of its 
consolidated return year, the disposition under paragraph (c)(1)(ii) of 
this section is treated as occurring immediately before the close of 
the year. If S becomes a nonmember because P sells S's stock to a 
nonmember, P's sale is a disposition under both paragraphs (c)(1) (i) 
and (ii) of this section. If a group terminates under Sec. 1.1502-75(d) 
because the common parent is the only remaining member, the common 
parent is not treated as having a deconsolidation event under paragraph 
(c)(1)(ii) of this section.
    (3) Exception for acquisition of group--(i) Application. This 
paragraph (c)(3) applies only if a consolidated group (the terminating 
group) ceases to exist as a result of--
    (A) The acquisition by a member of another consolidated group of 
either the assets of the common parent of the terminating group in a 
reorganization described in section 381(a)(2), or the stock of the 
common parent of the terminating group; or
    (B) The application of the principles of Sec. 1.1502-75(d)(2) or 
(d)(3).
    (ii) General rule. Paragraph (c)(1)(ii) of this section does not 
apply solely by reason of the termination of a group in a transaction 
to which this paragraph (c)(3) applies, if there is a surviving group 
that is, immediately thereafter, a consolidated group. Instead, the 
surviving group is treated as the terminating group for purposes of 
applying this section to the terminating group. This treatment does not 
apply, however, to members of the terminating group that are not 
members of the surviving group immediately after the terminating group 
ceases to exist (e.g., under section 1504(a)(3) relating to 
reconsolidation, or section 1504(c) relating to includible insurance 
companies).
    (d) Special allocation of basis adjustments or determinations. If a 
member has an excess loss account in shares of a class of S's stock at 
the time of a basis adjustment or determination under the Internal 
Revenue Code with respect to other shares of the same class of S's 
stock owned by the member, the adjustment or determination is allocated 
first to equalize and eliminate that member's excess loss account. For 
example, if P owns 50 shares of S's only class of stock with a $100 
basis and 50 shares with a $100 excess loss account, and P contributes 
$200 to S without receiving additional shares, the contribution first 
eliminates P's excess loss account, then increases P's basis in each 
share by $1. (If P transfers the $200 in exchange for an additional 100 
shares of S's stock in a transaction to which section 351 applies, P's 
excess loss account is first eliminated, and P's basis in the 
additional shares is $100.) See Sec. 1.1502-32(c) for similar 
allocations of investment adjustments to prevent or eliminate excess 
loss accounts.
    (e) Anti-avoidance rule. If any person acts with a principal 
purpose contrary to the purposes of this section, to avoid the effect 
of the rules of this section or apply the rules of this section to 
avoid the effect of any other provision of the consolidated return 
regulations, adjustments must be made as necessary to carry out the 
purposes of this section.
    (f) Predecessors and successors. For purposes of this section, any 
reference to a corporation (or to a share of the corporation's stock) 
includes a reference to a successor or predecessor (or to a share of 
stock of a predecessor or successor), as the context may require.
    (g) Examples. For purposes of the examples in this section, unless 
otherwise stated, P owns all of the only class of S's stock and S owns 
all of the only class of T's stock, the stock is owned for the entire 
year, T owns no stock of lower-tier members, the tax year of all 
persons is the calendar year, all persons use the accrual method of 
accounting, the facts set forth the only corporate activity, all 
transactions are between unrelated persons, and tax liabilities are 
disregarded. The principles of this section are illustrated by the 
following examples.

    Example 1. Taxable disposition of stock. (a) Facts. P has a $150 
basis in S's stock, and S has a $100 basis in T's stock. For Year 1, 
P has $500 of ordinary income, S has no income or loss, and T has a 
$200 ordinary loss. S sells T's stock to a nonmember for $60 at the 
close of Year 1.
    (b) Analysis. Under paragraph (c) of this section, the sale is a 
disposition of T's stock at the close of Year 1 (the day of the 
sale). Under Sec. 1.1502-32(b), T's loss results in S having a $100 
excess loss account in T's stock immediately before the sale. Under 
paragraph (b)(1) of this section, S takes into account the $100 
excess loss account as an additional $100 of gain from the sale. 
Consequently, S takes into account a $160 gain from the sale in 
determining the group's consolidated taxable income. Under 
Sec. 1.1502-32(b), T's $200 loss and S's $160 gain result in a net 
$40 decrease in P's basis in S's stock as of the close of Year 1, 
from $150 to $110.
    (c) Intercompany sale followed by sale to nonmember. The facts 
are the same as in paragraph (a) of this Example 1, except that S 
sells T's stock to P for $60 at the close of Year 1, and P sells T's 
stock to a nonmember at a gain at the beginning of Year 5. Under 
paragraph (c) of this section, S's sale is treated as a disposition 
of T's stock at the close of Year 1 (the day of the sale). Under 
Sec. 1.1502-13 and paragraph (b)(2) of this section, S's $160 gain 
from the sale is deferred and taken into account in Year 5 as a 
result of P's sale of the T stock. Under Sec. 1.1502-32(b), the 
absorption of T's $200 loss in Year 1 results in P having a $50 
excess loss account in S's stock at the close of Year 1. In Year 5, 
S's $160 gain taken into account eliminates P's excess loss account 
in S's stock and increases P's basis in the stock to $110.
    (d) Intercompany distribution followed by sale to a nonmember. 
The facts are the same as in paragraph (a) of this Example 1, except 
that the value of the T stock is $60 and S declares and distributes 
a dividend of all of the T stock to P at the close of Year 1, and P 
sells the T stock to a nonmember at a gain at the beginning of Year 
5. Under paragraph (c) of this section, S's distribution is treated 
as a disposition of T's stock at the close of Year 1 (the day of the 
distribution). S's $100 excess loss account in T's stock is treated 
as additional gain under section 311(b) from the distribution. Under 
Sec. 1.1502-14(a), P's basis in the T stock is $60. Under 
Sec. 1.1502-14, Sec. 1.1502-14T, and paragraph (b)(2) of this 
section, S's $160 gain from the distribution is deferred and taken 
into account in Year 5 as a result of P's sale of the T stock. Under 
Sec. 1.1502-32(b), T's $200 loss and S's $60 distribution result in 
P having a $110 excess loss account in S's stock at the close of 
Year 1. In Year 5, S's $160 gain taken into account eliminates P's 
excess loss account in S's stock and increases P's basis in the 
stock to $50.
    Example 2. Basis determinations under the Internal Revenue Code 
in intercompany reorganizations. (a) Facts. P owns all of the stock 
of S and T. P has a $150 basis in S's stock and a $100 excess loss 
account in T's stock. P transfers T's stock to S without receiving 
additional S stock, in a transaction to which section 351 applies.
    (b) Analysis. Under paragraph (c) of this section, P's transfer 
is treated as a disposition of T's stock. Under section 351 and 
paragraph (b)(2) of this section, P does not recognize gain from the 
disposition. Under section 358 and paragraph (a)(2)(ii) of this 
section, P's $100 excess loss account in T's stock decreases P's 
$150 basis in S's stock to $50. In addition, S takes a $100 excess 
loss account in T's stock under section 362. (If P had received 
additional S stock, paragraph (d) of this section would not apply to 
shift basis from P's original S stock because the basis of the 
original stock is not adjusted or determined as a result of the 
contribution; but paragraph (d) would apply to shift basis if P had 
transferred S's stock to T in exchange for additional T stock, 
because the basis of the additional T stock would be determined when 
P has an excess loss account in its original T stock.)
    (c) Intercompany merger. The facts are the same as in paragraph 
(a) of this Example 2, except that T merges into S in a 
reorganization described in section 368(a)(1)(A) (and in section 
368(a)(1)(D)), and P receives no additional S stock in the 
reorganization. Under section 354 and paragraph (b)(2) of this 
section, P does not recognize gain. Under section 358 and paragraph 
(a)(2)(ii) of this section, P's $100 excess loss account in T's 
stock decreases P's $150 basis in the S stock to $50. (Similarly, if 
S merges into T and P does not receive additional T stock, P's $150 
basis in S's stock eliminates P's excess loss account in T's stock, 
and increases P's basis in T's stock to $50.)
    (d) Liquidation of only subsidiary. Assume instead that P and S 
are the only members of the P group, P has a $100 excess loss 
account in S's stock, and S liquidates in a transaction to which 
section 332 applies. Under paragraph (c)(2) of this section, the 
liquidation is not a deconsolidation event under paragraph 
(c)(1)(ii) of this section merely because P is the only remaining 
member. Under section 332 and paragraph (b)(2) of this section, P 
does not recognize gain. Under section 334(b), P succeeds to S's 
basis in the assets it receives from S in the liquidation. (P would 
also not recognize gain if P transferred all of its assets 
(including S's stock) to S in a reorganization to which section 
361(a) applied, because S would be a successor to P under paragraph 
(f) of this section.)
    Example 3. Section 355 distribution of stock with an excess loss 
account. (a) Facts. P has a $30 excess loss account in S's stock, 
and S has a $90 excess loss account in T's stock. S distributes the 
T stock to P in a transaction to which section 355 applies, and 
neither P nor S recognizes any gain or loss. At the time of the 
distribution, the T stock represents 33% of the value of the S 
stock. Following the distribution, P's basis in the S stock is 
allocated under Sec. 1.358-2 in proportion to the fair market values 
of the S stock and the T stock.
    (b) Analysis. Under paragraph (c) of this section, S's 
distribution of the T stock is treated as a disposition. Under 
section 355(c) and paragraph (b)(2) of this section, S does not 
recognize any gain from the distribution. Under section 358, S's 
excess loss account in the T stock is eliminated, and P's $30 excess 
loss account in the S stock is treated as basis allocated between 
the S stock and the T stock based on their relative values. 
Consequently, P has a $20 excess loss account in the S stock and a 
$10 excess loss account in the T stock. (If P had a $30 basis rather 
than a $30 excess loss account in the S stock, S would not recognize 
gain, its excess loss account in the T stock would be eliminated, 
and P's basis in the stock of S and T would be $20 and $10, 
respectively.)
    (c) Section 355 distribution to nonmember. The facts are the 
same as in paragraph (a) of this Example 3, except that P also 
distributes the T stock to its shareholders in a transaction to 
which section 355 applies. Under paragraph (c) of this section, P's 
distribution is treated as a disposition of T's stock. Under 
paragraph (b)(2) of this section, because P's disposition is 
described in paragraph (c)(1)(ii) of this section, P's $10 excess 
loss account in the T stock must be taken into account at the time 
of the distribution, notwithstanding the nonrecognition rules of 
section 355(c).
    Example 4. Deconsolidation of a member. (a) Facts. P has a $50 
excess loss account in S's stock, and S has a $100 excess loss 
account in T's stock. T issues additional stock to a nonmember and, 
as a consequence, T becomes a nonmember.
    (b) Analysis. Under paragraph (c)(2) of this section, S is 
treated as disposing of T's stock immediately before T becomes a 
nonmember. Under paragraph (b)(1) of this section, S takes into 
account its $100 excess loss account as gain from the sale or 
exchange of T's stock. Under Sec. 1.1502-32(b) of this section, S's 
$100 gain eliminates P's excess loss account in S's stock and 
increases P's basis in S's stock to $50.
    (c) Deconsolidation of a higher-tier member. The facts are the 
same as in paragraph (a) of this Example 4, except that S (rather 
than T) issues the stock and, as a consequence, both S and T become 
nonmembers. Under paragraph (c)(2) of this section, P is treated as 
disposing of S's stock and S is treated as disposing of T's stock 
immediately before S and T become nonmembers. Under Sec. 1.1502-
32(b) and paragraph (b)(3) of this section, because S and T become 
nonmembers in the same transaction and T is the lower-tier member, S 
is first treated under paragraph (b)(1) of this section as taking 
into account its $100 excess loss account as gain from the sale or 
exchange of T's stock. Under Sec. 1.1502-32(b), S's $100 gain 
eliminates P's excess loss account in S's stock and increases P's 
basis in S's stock to $50 immediately before S becomes a nonmember. 
Thus, only S's $100 gain is taken into account in the determination 
of the group's consolidated taxable income.
    (d) Intercompany gain and deconsolidation. The facts are the 
same as in paragraph (c) of this Example 4, except that T has $30 of 
gain that is deferred under Sec. 1.1502-13 and taken into account in 
determining consolidated taxable income immediately before T becomes 
a nonmember. Under Sec. 1.1502-32(b), T's $30 gain decreases S's 
excess loss account in T's stock from $100 to $70 immediately before 
S is treated as disposing of T's stock. Under paragraph (b)(1) of 
this section, S is treated as taking into account its $70 excess 
loss account as gain from the disposition of T's stock. Under 
Sec. 1.1502-32(b), S's $70 gain from the excess loss account and T's 
$30 deferred gain that is taken into account eliminate P's $50 
excess loss account in S's stock and increase P's basis in S's stock 
to $50 immediately before S becomes a nonmember.
    Example 5. Worthlessness. (a) Facts. P forms S with a $150 
contribution, and S borrows $150. For Year 1, S has a $50 ordinary 
loss that is carried over as part of the group's consolidated net 
operating loss. For Year 2, P has $160 of ordinary income, and S has 
a $160 ordinary loss. Under Sec. 1.1502-32(b), S's loss results in P 
having a $10 excess loss account in S's stock. During Year 3, the 
value of S's assets (without taking S's liabilities into account) 
continues to decline and S's stock becomes worthless within the 
meaning of section 165(g) (without taking into account Sec. 1.1502-
80(c)). For Year 4, S has $10 of ordinary income.
    (b) Analysis. Under paragraph (c)(1)(iii)(A) of this section, P 
is not treated as disposing of S's stock in Year 3 solely because 
S's stock becomes worthless within the meaning of section 165(g) 
(taking S's liabilities into account). In addition, because S's 
stock is not treated as worthless, section 382(g)(4)(D) does not 
prevent the Year 1 consolidated net operating loss carryover from 
offsetting S's $10 of income in Year 4.
    (c) Discharge of indebtedness. The facts are the same as in 
paragraph (a) of this Example 5, except that, instead of S's stock 
becoming worthless within the meaning of section 165(g), S's 
creditor discharges $40 of S's indebtedness during Year 3, S is 
insolvent by more than $40 before the discharge, the discharge is 
excluded from the P group's gross income under section 108(a), and 
$40 of the $50 consolidated net operating loss carryover 
attributable to S is eliminated under section 108(b). Under 
Sec. 1.1502- 32(b)(3)(ii)(C), S's $40 of discharge income is treated 
as tax-exempt income because there is a corresponding decrease under 
Sec. 1.1502-32(b)(3)(iii) for elimination of the loss carryover. 
Under paragraph (c)(1)(iii)(B) of this section, P is treated as 
disposing of S's stock if the amount discharged is not included in 
gross income and is not treated as tax-exempt income under 
Sec. 1.1502-32(b)(3)(ii)(C). Because the discharge is treated as 
tax-exempt income, P is not treated as disposing of S's stock by 
reason of the discharge.
    Example 6. Avoiding worthlessness. (a) Facts. P forms S with a 
$100 contribution and S borrows $150. For Years 1 through 5, S has a 
$210 ordinary loss that is absorbed by the group. Under Sec. 1.1502-
32(b), S's loss results in P having a $110 excess loss account in 
S's stock. S defaults on the indebtedness, but the creditor does not 
discharge the debt (or initiate collection procedures). At the 
beginning of Year 6, S ceases any substantial operations with 
respect to the assets, but maintains their ownership with a 
principal purpose to avoid P's taking into account its excess loss 
account in S's stock.
    (b) Analysis. Under paragraph (c)(1)(iii)(A) of this section, 
P's excess loss account ordinarily is taken into account at the time 
substantially all of S's assets are treated as disposed of, 
abandoned, or destroyed for Federal income tax purposes. Under 
paragraph (e) of this section, however, S's assets are not taken 
into account at the beginning of Year 6 for purposes of applying 
paragraph (c)(1)(iii)(A) of this section. Consequently, S is treated 
as worthless at the beginning of Year 6, and P's $110 excess loss 
account is taken into account.

    (h) Effective date--(1) Application. This section applies with 
respect to determinations of the basis of (including an excess loss 
account in) the stock of a member in consolidated return years 
beginning on or after January 1, 1995. If this section applies, basis 
(and excess loss accounts) must be determined or redetermined as if 
this section were in effect for all years (including, for example, the 
consolidated return years of another consolidated group to the extent 
adjustments during those consolidated return years are still 
reflected). Any such determination or redetermination does not, 
however, affect any prior period.
    (2) Dispositions of stock before effective date--(i) In general. If 
P was treated as disposing of stock of S in a tax year beginning before 
January 1, 1995 (including, for example, a deemed disposition because S 
was worthless) under the rules of this section then in effect, the 
amount of P's income, gain, deduction, or loss, and the stock basis 
reflected in that amount, are not redetermined under paragraph (h)(1) 
of this section. See paragraph (h)(3) of this section for the 
applicable rules.
    (ii) Intercompany amounts. For purposes of this paragraph (h)(2), a 
disposition does not include a transaction to which Sec. 1.1502-13, 
Sec. 1.1502-13T, Sec. 1.1502-14, or Sec. 1.1502-14T applies. Instead, 
the transaction is deemed to occur as the income, gain, deduction, or 
loss (if any) is taken into account.
    (3) Prior law. For prior determinations, see prior regulations 
under section 1502 as in effect with respect to the determination. See, 
e.g., Sec. 1.1502-19 as contained in the 26 CFR part 1 edition revised 
as of April 1, 1994.
    Par. 10. Section 1.1502-20 is amended as follows:
    1. Paragraphs (a)(1) and (a)(3)(ii) are revised.
    2. The last sentence of paragraph (a)(4) is removed.
    3. The introductory text in paragraph (a)(5) is revised.
    4. In paragraph (a)(5), paragraph (iii) in Example 6 is removed.
    5. The last sentence of paragraph (b)(4) is removed.
    6. In paragraph (b)(6), the last sentence of paragraph (iv) in 
Example 5 is revised.
    7. Paragraphs (c)(1) (i) and (ii) are revised.
    8. Paragraphs (c)(2)(i)(A)(1), (B), and (D) are revised.
    9. The first sentence of the concluding text of paragraph (c)(2)(i) 
appearing immediately after paragraph (c)(2)(i)(D) is revised.
    10. Paragraphs (c)(2) (ii) and (iii) are revised.
    11. Paragraph (c)(2)(vii) is added.
    12. Paragraph (c)(4) is amended as follows:
    a. The heading for Example 1 and paragraphs (ii) and (iii) of 
Example 1 are revised.
    b. Example 2 is revised.
    c. The fifth sentence of paragraph (i) of Example 3 is revised.
    d. Paragraphs (ii) and (iii) of Example 3 are revised.
    e. Paragraph (ii) of Example 6 is revised.
    f. Example 7 is revised.
    13. Paragraph (e)(3) is amended as follows:
    a. Example 1 is revised.
    b. Example 2 is amended by replacing the reference to 
``Sec. 1.267(f)-2T(d)(2)'' in paragraph (ii) with ``section 267(f)''.
    c. Example 8 is removed.
    14. Paragraph (f) is revised.
    15. Paragraph (g)(3) is removed, and paragraph (g)(4) is 
redesignated as paragraph (g)(3).
    16. Newly designated paragraph (g)(3) is amended by revising 
paragraphs (i) and (iii) of Example 1, paragraphs (i) and (iv) of 
Example 2, and paragraph (iv) of Example 3.
    17. The added and revised provisions read as follows:


Sec. 1.1502-20   Loss disallowance.

    (a) Loss disallowance--(1) General rule. No deduction is allowed 
for any loss recognized by a member with respect to the disposition of 
stock of a subsidiary. See also Secs. 1.1502-15(b) (stock losses 
attributable to certain pre-1966 distributions) and 1.1502-80(c) 
(deferring the treatment of stock of members as worthless under section 
165(g)).
* * * * *
    (3) * * *
    (ii) Overriding events. For purposes of paragraph (a)(3)(i) of this 
section, the following are overriding events:
    (A) The stock ceases to be owned by a member of the consolidated 
group.
    (B) The stock is canceled or redeemed (regardless of whether it is 
retired or held as treasury stock).
    (C) The stock is treated as disposed of under Sec. 1.1502-
19(c)(1)(ii)(B) or (c)(1)(iii).
* * * * *
    (5) Examples. For purposes of the examples in this section, unless 
otherwise stated, all corporations have only one class of stock 
outstanding, all groups file consolidated returns on a calendar-year 
basis, the facts set forth the only corporate activity, all 
transactions are between unrelated persons, and tax liabilities are 
disregarded. The basis of each asset is the same for determining 
earnings and profits adjustments and taxable income. References to the 
investment adjustment system are references to the rules of 
Secs. 1.1502-19, 1.1502-32 and 1.1502-33. The principles of this 
paragraph (a) are illustrated by the following examples.
* * * * *
    (b) * * *
    (6) * * *
* * * * *
    Example 5. * * *
    (iv) * * * However, the subsequent deconsolidation of the T 
stock is an overriding event under paragraph (a)(3)(ii) of this 
section, and paragraph (a)(1) of this section applies to the loss 
immediately before the deconsolidation.
* * * * *
    (c) * * *
    (1) * * *
    (i) Extraordinary gain dispositions. The amount of income or gain 
(or its equivalent), net of directly related expenses, that is 
allocated to the share from extraordinary gain dispositions.
    (ii) Positive investment adjustments. The amount of the positive 
adjustment (if any) with respect to the share under Sec. 1.1502-32 for 
each consolidated return year, but only to the extent the amount 
exceeds the amount described in paragraph (c)(1)(i) of this section for 
the year.
* * * * *
    (2) * * *
    (i) * * *
    (A) * * *
    (1) A capital asset as defined in section 1221 (determined without 
the application of any other rules of law).
* * * * *
    (B) A positive section 481(a) adjustment.
* * * * *
    (D) Any other event (or item) identified in guidance published in 
the Internal Revenue Bulletin.

An extraordinary gain disposition is taken into account under paragraph 
(c)(1)(i) of this section only if it occurs on or after November 19, 
1990. * * *

    (ii) Positive investment adjustments. For purposes of paragraph 
(c)(1)(ii) of this section, a positive adjustment under Sec. 1.1502-32 
is the sum of the amounts under Sec. 1.1502-32(b)(2) (i) through (iii) 
for the consolidated return year (the adjustment determined without 
taking distributions into account). However, amounts included in any 
loss carryover are taken into account in the year they arise rather 
than the year absorbed.
    (iii) Applicable amounts. Amounts are described in paragraphs 
(c)(1)(i) and (ii) of this section only to the extent they are 
reflected in the basis of the share, directly or indirectly, 
immediately before the disposition or deconsolidation. For this 
purpose, an amount is reflected in the basis of a share if the share's 
basis would have been different without the amount. However, amounts 
included in any loss carryover are taken into account in the year they 
arise rather than the year absorbed.
* * * * *
    (vii) Disallowance amounts applied only once. The amounts described 
in paragraph (c)(1) of this section are not applied more than once to 
disallow a loss, reduce basis, or reattribute loss under this section.
* * * * *
    (4) * * *

    Example 1. Allowable loss attributable to lost built-in gain. * 
* *
    (ii) The amount of the $100 loss disallowed under paragraph 
(a)(1) of this section may not exceed the amount determined under 
paragraph (c)(1) of this section. Under paragraphs (c)(2) (i) and 
(iii) of this section, T's $40 gain is from an extraordinary gain 
disposition and the amount is reflected in the basis of the T stock 
under Sec. 1.1502-32 immediately before the disposition. Thus, the 
gain is described in paragraph (c)(1)(i) of this section. Because 
this amount is the only amount described in paragraph (c)(1) of this 
section, the amount of P's $100 loss that is disallowed under 
paragraph (a)(1) of this section is limited to $40. (No amount is 
described in paragraph (c)(1)(ii) of this section because the amount 
of T's positive investment adjustments does not exceed the amount 
included under paragraph (c)(1)(i) of this section.)
    (iii) The results would be the same if the asset, instead of 
being owned by T, is owned by a partnership in which T is a partner 
and T is allocated the $40 of gain under section 704(b). Under 
paragraphs (c)(2) (i) and (iii) of this section, T's $40 gain is 
from an extraordinary gain disposition, and the gain is reflected in 
the basis of the T stock under Sec. 1.1502-32 immediately before the 
disposition.
    Example 2. Extraordinary gain dispositions. (i) Individual A 
forms T. P buys all the stock of T from A for $100 in Year 1, and T 
becomes a member of the P group. T owns a capital asset, asset 1, 
with a basis of $0 and a value of $100. T sells asset 1 for $100 in 
Year 1 and invests the proceeds in a trade or business asset, asset 
2. For Year 2, asset 2 produces $30 of gross operating income and 
$20 of cost recovery deductions. On December 31 of Year 2, asset 2 
has an $80 adjusted basis and T disposes of asset 2 for $85; 
however, because T incurs $20 of expenses directly related to the 
sale of asset 2, the disposition produces a $15 loss that is taken 
into account in the determination of taxable income or loss under 
Sec. 1.1502-32(b)(2)(i) (the loss offsets T's $10 of operating 
income for Year 2, as well as $5 of operating income of P in that 
year). Under the investment adjustment system, P's basis in the T 
stock increases by $95, to $195, because T has $110 of income and a 
$15 loss. P sells the T stock for $95 in Year 5 and recognizes a 
$100 loss.
    (ii) Under paragraphs (c)(2) (i) and (iii) of this section, the 
$100 gain from the disposition of asset 1 is from an extraordinary 
gain disposition and is reflected in the basis of the T stock. Thus, 
the gain is described in paragraph (c)(1)(i) of this section. The 
sale of asset 2 is not taken into account under paragraph (c)(1)(i) 
of this section because, net of directly related expenses, T does 
not have income or gain from the sale. (No amount is described under 
paragraph (c)(1)(ii) of this section because T's positive investment 
adjustments are taken into account under paragraph (c)(1)(i) of this 
section.) Because the $100 amount described under paragraph 
(c)(1)(i) of this section equals P's $100 loss from the disposition 
of the T stock, all of the loss is disallowed.
    Example 3. * * * (i) * * * T invests the operating income in 
another asset that produces a $25 operating loss for Year 2. * * *
    (ii) Under paragraph (c)(1)(ii) of this section, the $100 of 
income from Year 1 is a positive investment adjustment. The amount 
is not reduced by the $25 operating loss for Year 2. Because the 
$100 amount described under paragraph (c)(1)(ii) of this section 
equals S's $100 loss from the disposition of the T stock, all of the 
loss is disallowed.
    (iii) Under paragraph (c)(2)(iv) of this section, the results 
would have been the same if, prior to the decline in the value of 
the first asset (the value of the T stock was $200, $100 cash and a 
$100 asset), S had sold the T stock to P for $200 at no gain or 
loss, and P then sold the T stock to an unrelated buyer for $75 
(after the $100 decline in the value of the asset and the $25 
operating loss) and recognized a $100 loss. T had $100 of income 
that resulted in a positive adjustment under the investment 
adjustment system and is reflected, within the meaning of paragraph 
(c)(2)(iii) of this section, in the basis of the T stock. The income 
and investment adjustments with respect to the T stock are not 
reduced or eliminated for purposes of paragraph (c)(1)(ii) of this 
section by reason of P's purchase of the stock, because P is a 
person related to S within the meaning of section 267(b).
* * * * *
    Example 6. * * *
    (ii) Although T has a $100 gain from extraordinary gain 
dispositions, the gain is not reflected in P's basis in the T stock 
within the meaning of paragraph (c)(2)(iii) of this section. P's 
basis reflects the stock's value at the time of P's purchase, and is 
determined without regard to whether T recognized the gain before 
the purchase. Thus, no part of T's gain is described in paragraph 
(c)(1) of this section, and no part of the $20 loss is disallowed 
under paragraph (a) of this section. (For rules that apply if A and 
P are related persons, see paragraph (c)(2)(iv) of this section.)
    Example 7. Adjustments to stock basis under applicable rules of 
law. (i) Individual A forms T, and T's assets subsequently 
appreciate. T borrows $100 on a nonrecourse basis secured by the 
appreciated assets. P buys all of the stock of T from A for $150. 
After becoming a member of the P group, T has a $100 operating loss 
that is absorbed in the determination of consolidated taxable income 
and P's basis in the T stock is reduced to $50 under Sec. 1.1502-32. 
Because T's assets have declined in value, T's creditors discharge 
$60 of T's indebtedness. The $60 discharge is not included in T's 
gross income under section 108(a), but no attributes are reduced 
under section 108(b).
    (ii) Under paragraph (c)(2)(i) of this section, the discharge of 
indebtedness is an extraordinary gain disposition. Under 
Sec. 1.1502-32(b)(3)(ii), however, the $60 discharge of indebtedness 
is not treated as tax-exempt income that increases P's basis in the 
T stock. Consequently, under paragraph (c)(2)(iii) of this section, 
T's discharge of indebtedness income is not reflected in P's basis 
in the T stock. Thus, there is no amount under paragraph (c)(1) of 
this section.
    (iii) The facts are the same as in paragraph (i) of this 
Example, except that $60 of T's operating loss is not absorbed and 
is included in a consolidated net operating loss that is carried 
over under Sec. 1.1502-21, and the $60 is eliminated from the 
carryover under section 108(b) as a result of T's discharge of 
indebtedness. The absorption of $40 of T's loss reduces P's basis in 
the T stock from $150 to $110. The $60 discharge of indebtedness is 
treated as tax-exempt income that increases P's basis in the T 
stock, and the $60 attribute reduction is treated as a noncapital, 
nondeductible expense that reduces P's basis in the T stock. Thus, 
P's basis in T's stock remains $110 following the discharge and 
attribute reduction. Because P's basis is $110, rather than $50, the 
discharge of indebtedness income is reflected in P's basis for 
purposes of paragraph (c)(2)(iii) of this section. Thus, the amount 
under paragraph (c)(1)(i) of this section is $60.
* * * * *
    (e) * * *
    (3) * * *
    Example 1. Shifting of value. (i) 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. With the view described in 
paragraph (e)(1) of this section, P transfers land with a value of 
$100 to T in exchange for preferred stock with a $200 redemption 
price and liquidation preference. The $100 redemption premium (the 
excess of the $200 redemption price over the $100 issue price) 
ultimately increases the value of the preferred stock from $100 to 
$200 (and decreases the value of the common stock). T sells the 
built-in gain asset for $100, and P's aggregate basis in S's common 
and preferred stock increases to $300. In addition, as a result of a 
cumulative redetermination under Sec. 1.1502-32(c)(4), P's basis in 
the T preferred stock increases from $100 to $200 and P's basis in 
the common stock remains $100. P subsequently sells the common stock 
at a loss.
    (ii) Under section 305, the redemption premium is treated as a 
distribution of property to which section 301 applies. Under 
Secs. 1.1502-14 and 1.1502-32, P's aggregate basis in the preferred 
and common stock is unaffected by the deemed distributions.
    (iii) P's loss on the sale of the common stock is disallowed 
under paragraph (e)(1) of this section. This disallowance prevents 
the preferred stock from shifting value and stock basis adjustments 
from the common stock to avoid the disallowance of loss under this 
section.
* * * * *
    (f) No tiering up of certain adjustments--(1) General rule. If the 
basis of stock of a subsidiary (S) owned by a another member (P) is 
reduced under this section on the deconsolidation of the S stock, no 
corresponding adjustment is made under Sec. 1.1502-32 to the basis of 
the stock of P if there is a disposition or deconsolidation of the P 
stock in the same transaction. If there is a disposition or 
deconsolidation in the same transaction of less than all the stock of 
P, appropriate adjustments must be made under Sec. 1.1502-32 with 
respect to P (and any higher-tier members).
    (2) Example. The principles of this paragraph (f) are illustrated 
by the following example.

    Example. (i) P, the common parent of a group, owns all the stock 
of S, S owns all the stock of S1, and S1 owns all the stock of S2. 
P's basis in the S stock is $100, S's basis in the S1 stock is $100, 
and S1's basis in the S2 stock is $100. In Year 1, S2 buys all the 
stock of T for $100. T has an asset with a basis of $0 and a value 
of $100. In Year 2, T sells the asset for $100. Under the investment 
adjustment system, the basis of each subsidiary's stock increases 
from $100 to $200. In Year 6, S sells all the stock of S1 for $100 
to A, an individual, and recognizes a loss of $100. S1, S2, and T 
are not members of a consolidated group immediately after the sale 
because the new S1 group does not file a consolidated return for its 
first tax year.
    (ii) Under paragraph (a)(1) of this section, no deduction is 
allowed to S for its loss from the sale of the S1 stock. Under 
Sec. 1.1502-32(b)(3)(iii), S's disallowed loss is treated as a 
noncapital, nondeductible expense for Year 6 that reduces P's basis 
in the S stock. (Under Sec. 1.1502-33, S's earnings and profits for 
Year 6 are reduced by the amount of S's disallowed loss for earnings 
and profits purposes and, under Sec. 1.1502-33(b), this reduction is 
reflected in P's earnings and profits.)
    (iii) Under paragraphs (b)(1) and (f)(1) of this section, 
because the stock of T and S2 are deconsolidated as a result of S's 
sale of the S1 stock, the basis of their stock must be reduced 
immediately before the sale from $200 to $100 (the value immediately 
before the deconsolidation). Under Sec. 1.1502-32(b)(3)(iii), the 
basis reductions are treated as noncapital, nondeductible expenses 
for Year 6. Under paragraph (f)(2) of this section, however, because 
the S2 stock is deconsolidated in the same transaction, the basis 
reduction to the T stock does not tier up under Sec. 1.1502-
32(a)(3). Similarly, because the S1 stock is disposed of in the same 
transaction, the basis reduction to the S2 stock also does not tier 
up. (Comparable treatment applies for purposes of earnings and 
profits under Sec. 1.1502-33.)
    (g) * * *
    (3) * * *
    Example 1. * * * (i) P, the common parent of a group, forms S 
with a $100 contribution. For Year 1, S has a $60 operating loss 
that is not absorbed and is included in the group's consolidated net 
operating loss that is carried over under Sec. 1.1502-21. Under 
Sec. 1.1502-32(b)(3)(i), P's basis in the S stock is not reduced to 
reflect S's loss because the loss is not absorbed. Under 
Sec. 1.1502-33(b), S's deficit in earnings and profits is reflected 
in P's earnings and profits even though the loss is not absorbed for 
tax purposes. During Year 2, S's remaining assets appreciate in 
value and P sells the S stock for $55. But for an election to 
reattribute losses under paragraph (g) of this section, P would have 
a $45 loss from the sale that would be disallowed.
* * * * *
    (iii) Under Sec. 1.1502-32(b)(3)(iii), the reattribution of $45 
of loss is a noncapital, nondeductible expense that reduces P's 
basis in the S stock from $100 to $55 immediately before the 
disposition. Consequently, P does not recognize any gain or loss 
from the disposition.
* * * * *
    Example 2. * * * (i) P, the common parent of a group, forms S 
with a $100 contribution. S then forms T with a $40 contribution and 
T borrows $60. For Year 1, S has a $30 operating loss and T has a 
$55 operating loss. The losses are not absorbed and are included in 
the group's consolidated net operating loss that is carried over 
under Sec. 1.1502-21. Under Sec. 1.1502-32(b)(3)(i), P's basis in 
the S stock, and S's basis in the T stock, are not reduced to 
reflect the S and T losses because the group is unable to absorb the 
losses. (Under Sec. 1.1502-33(b), the deficits in earnings and 
profits of S and T are tiered up for earnings and profits purposes 
even though not absorbed for tax purposes.) During Year 2, P sells 
the S stock for $30 ($100 invested, minus S's $30 loss and $40 
unrealized loss from its investment in the T stock). But for an 
election to reattribute losses under paragraph (g) of this section, 
P would have a $70 loss from the sale, which would be disallowed.
* * * * *
    (iv) Under Sec. 1.1502-32(b)(3)(iii), the reattribution of loss 
is a noncapital, nondeductible expense that reduces P's basis in the 
S stock to $60 immediately before the disposition. Consequently, P 
recognizes only a $30 loss from the disposition of its S stock ($30 
sale proceeds and $60 basis), and this loss is disallowed.
    Example 3. * * *
    (iv) Under Sec. 1.1502-32(b)(3)(iii), the reattribution of loss 
is a noncapital, nondeductible expense that reduces P's basis in the 
S stock to $60 immediately before the disposition. Consequently, P 
recognizes no gain or loss from the disposition of its S stock. For 
P's treatment of the $40 reattributed loss, see Sec. 1.1502-1(f).
* * * * *
    Par. 11. Section 1.1502-31 is revised to read as follows:


Sec. 1.1502-31   Stock basis after a group structure change.

    (a) In general--(1) Overview. If one corporation (P) succeeds 
another corporation (T) under the principles of Sec. 1.1502-75(d) (2) 
or (3) as the common parent of a consolidated group in a group 
structure change, the basis of members in the stock of the former 
common parent (or the stock of a successor) is adjusted or determined 
under this section. See Sec. 1.1502-33(f)(1) for the definition of 
group structure change. For example, if P owns all of the stock of 
another corporation (S), and T merges into S in a group structure 
change that is a reorganization described in section 368(a)(2)(D) in 
which P becomes the common parent of the T group, P's basis in S's 
stock must be adjusted to reflect the change in S's assets and 
liabilities. The rules of this section coordinate with the earnings and 
profits adjustments required under Sec. 1.1502-33(f)(1), generally 
conforming the results of transactions in which the T group continues 
under Sec. 1.1502-75 with P as the common parent. By preserving in P 
the relationship between T's earnings and profits and asset basis, 
these adjustments limit possible distortions under section 1502 (e.g., 
in the deconsolidation rules for earnings and profits under 
Sec. 1.1502-33(e), and the continued filing requirements under 
Sec. 1.1502-75(a)). This section applies whether or not T continues to 
exist after the group structure change.
    (2) Application of other rules of law. The rules of this section 
are in addition to other rules of law. The provisions of this section 
and other rules of law must not have the effect of duplicating an 
amount in P's basis in S's stock.
    (b) General rules. Except as otherwise provided in this section--
    (1) Asset acquisitions. If a corporation acquires the former common 
parent's assets (and any liabilities assumed or to which the assets are 
subject) in a group structure change, the basis of members in the stock 
of the acquiring corporation is adjusted immediately after the group 
structure change to reflect the acquiring corporation's allocable share 
of the former common parent's net asset basis as determined under 
paragraph (c) of this section. For example, if S acquires all of T's 
assets in a group structure change that is a reorganization described 
in section 368(a)(2)(D), P's basis in S's stock is adjusted to reflect 
T's net asset basis. If P owned some of T's stock before the group 
structure change, the results would be the same because P's basis in 
the T stock is not taken into account in determining P's basis in S's 
stock. If T's net asset basis is a negative amount, it reduces P's 
basis in S's stock and, if the reduction exceeds P's basis in S's 
stock, the excess is P's excess loss account in S's stock. See 
Sec. 1.1502-19 for rules treating P's excess loss account as negative 
basis, and treating a reference to P's basis in S's stock as including 
an excess loss account.
    (2) Stock acquisitions. If a corporation acquires stock of the 
former common parent in a group structure change, the basis of the 
members in the former common parent's stock immediately after the group 
structure change (including any stock of the former common parent owned 
before the group structure change) is redetermined in accordance with 
the results for an asset acquisition described in paragraph (b)(1) of 
this section. For example, if all of T's stock is contributed to P in a 
group structure change to which section 351 applies, P's basis in T's 
stock is T's net asset basis, rather than the amount determined under 
section 362. Similarly, if S merges into T in a group structure change 
described in section 368(a)(2)(E), P's basis in T's stock is the basis 
that P would have in S's stock under paragraph (b)(1) of this section 
if T had merged into S in a group structure change described in section 
368(a)(2)(D).
    (c) Net asset basis. The former common parent's net asset basis is 
the basis it would have in the stock of a newly formed subsidiary, if--
    (1) The former common parent transferred its assets (and any 
liabilities assumed or to which the assets are subject) to the 
subsidiary in a transaction to which section 351 applies;
    (2) The former common parent and the subsidiary were members of the 
same consolidated group (see Sec. 1.1502-80(d) for the non-application 
of section 357(c) to the transfer); and
    (3) The asset basis taken into account is each asset's basis 
immediately after the group structure change (e.g., taking into account 
any income or gain recognized in the group structure change and 
reflected in the asset's basis).
    (d) Additional adjustments. In addition to the adjustments in 
paragraph (b) of this section, the following adjustments are made:
    (1) Consideration not provided by P. The basis is reduced to 
reflect the fair market value of any consideration not provided by the 
member. For example, if S acquires T's assets in a group structure 
change described in section 368(a)(2)(D), and S provides an appreciated 
asset (e.g., stock of P) as partial consideration in the transaction, 
P's basis in S's stock is reduced by the fair market value of the 
asset.
    (2) Allocable share--(i) Asset acquisitions. If a corporation 
receives less than all of the former common parent's assets and 
liabilities in the group structure change, the former common parent's 
net asset basis taken into account under paragraph (b)(1) of this 
section is adjusted accordingly.
    (ii) Stock acquisitions. If a corporation owns less than all of the 
former common parent's stock immediately after a group structure change 
described in paragraph (b)(2) of this section, the percentage of the 
former common parent's net asset basis taken into account equals the 
percentage (by fair market value) of the former common parent's stock 
owned immediately after the group structure change. For example, if P 
owns less than all of the former common parent's stock immediately 
after the group structure change, only an allocable part of the basis 
determined under this section is reflected in the shares owned by P 
(and the amount allocable to shares owned by nonmembers has no effect 
on the basis of their shares).
    (3) Allocation among shares of stock. The basis determined under 
this section is allocated among shares under the principles of section 
358. For example, if P owns multiple classes of the former common 
parent's stock immediately after the group structure change, only an 
allocable part of the basis determined under this section is reflected 
in the basis of each share. See Sec. 1.1502-19(d), for special 
allocations with respect to excess loss accounts.
    (4) Higher-tier members. To the extent that the former common 
parent is owned by members other than the new common parent, the basis 
of members in the stock of all subsidiaries owning, directly or 
indirectly, in whole or in part, an interest in the former common 
parent's assets or liabilities is adjusted in accordance with the 
principles of this section. The adjustments are applied in the order of 
the tiers, from the lowest to the highest.
    (e) Waiver of loss carryovers of former common parent --(1) General 
rule. An irrevocable election may be made to treat all or any portion 
of a loss carryover attributable to the common parent as expiring for 
all Federal income tax purposes immediately before the group structure 
change. Thus, if the loss carryover is treated as expiring under the 
election, it will not result in a negative adjustment to the basis of 
P's stock under Sec. 1.1502-32(b).
    (2) Election. The election described in this paragraph (e) must be 
made in a separate statement entitled ``ELECTION TO TREAT LOSS 
CARRYOVER AS EXPIRING UNDER Sec. 1.1502-31(e).'' The statement must be 
filed with the consolidated group's return for the year that includes 
the group structure change, and it must be signed by the former and the 
new common parent. The statement must identify the amount of each loss 
carryover deemed to expire (or the amount of each loss carryover deemed 
not to expire, with any balance of any loss carryovers being deemed to 
expire).
    (f) Predecessors and successors. For purposes of this section, any 
reference to a corporation includes a reference to a successor or 
predecessor as the context may require. See Sec. 1.1502-32(f) for 
definitions of predecessor and successor.
    (g) Examples. For purposes of the examples in this section, unless 
otherwise stated, all corporations have only one class of stock 
outstanding, the tax year of all persons is the calendar year, all 
persons use the accrual method of accounting, the facts set forth the 
only corporate activity, all transactions are between unrelated 
persons, and tax liabilities are disregarded. The principles of this 
section are illustrated by the following examples.

    Example 1. Forward triangular merger. (a) Facts. P is the common 
parent of one group and T is the common parent of another. T has 
assets with an aggregate basis of $60 and fair market value of $100 
and no liabilities. T's shareholders have an aggregate basis of $50 
in T's stock. In Year 1, pursuant to a plan, P forms S and T merges 
into S with the T shareholders receiving $100 of P stock in exchange 
for their T stock. The transaction is a reorganization described in 
section 368(a)(2)(D). The transaction is also a reverse acquisition 
under Sec. 1.1502- 75(d)(3) because the T shareholders, as a result 
of owning T's stock, own more than 50% of the value of P's stock 
immediately after the transaction. Thus, the transaction is a group 
structure change under Sec. 1.1502-33(f)(1), and P's earnings and 
profits are adjusted to reflect T's earnings and profits immediately 
before T ceases to be the common parent of the T group.
    (b) Analysis. Under paragraph (b)(1) of this section, P's basis 
in S's stock is adjusted to reflect T's net asset basis. Under 
paragraph (c) of this section, T's net asset basis is $60, the basis 
T would have in the stock of a subsidiary under section 358 if T had 
transferred all of its assets and liabilities to the subsidiary in a 
transaction to which section 351 applies. Thus, P has a $60 basis in 
S's stock.
    (c) Pre-existing S. The facts are the same as in paragraph (a) 
of this Example 1, except that P has owned the stock of S for 
several years and P has a $50 basis in the S stock before the merger 
with T. Under paragraph (b)(1) of this section, P's $50 basis in S's 
stock is adjusted to reflect T's net asset basis. Thus, P's basis in 
S's stock is $110 ($50 plus $60).
    (d) Excess loss account included in former common parent's net 
asset basis. The facts are the same as in paragraph (a) of this 
Example 1, except that T has two assets, an operating asset with an 
$80 basis and $90 fair market value, and stock of a subsidiary with 
a $20 excess loss account and $10 fair market value. Under paragraph 
(c) of this section, T's net asset basis is $60 ($80 minus $20). See 
sections 351 and 358, and Sec. 1.1502-19. Consequently, P has a $60 
basis in S's stock. Under section 362 and Sec. 1.1502-19, S has an 
$80 basis in the operating asset and a $20 excess loss account in 
the stock of the subsidiary.
    (e) Liabilities in excess of basis. The facts are the same as in 
paragraph (a) of this Example 1, except that T's assets have a fair 
market value of $170 (and $60 basis) and are subject to $70 of 
liabilities. Under paragraph (c) of this section, T's net asset 
basis is ($10) ($60 minus $70). See sections 351 and 358, and 
Secs. 1.1502-19 and 1.1502-80(d). Thus, P has a $10 excess loss 
account in S's stock. Under section 362, S has a $60 basis in its 
assets (which are subject to $70 of liabilities). (Under paragraph 
(a)(2) of this section, because the liabilities are taken into 
account in determining net asset basis under paragraph (c) of this 
section, the liabilities are not also taken into account as 
consideration not provided by P under paragraph (d)(1) of this 
section.)
    (f) Consideration provided by S. The facts are the same as in 
paragraph (a) of this Example 1, except that P forms S with a $100 
contribution at the beginning of Year 1, and during Year 6, pursuant 
to a plan, S purchases $100 of P stock and T merges into S with the 
T shareholders receiving P stock in exchange for their T stock. 
Under paragraph (b)(1) of this section, P's $100 basis in S's stock 
is increased by $60 to reflect T's net asset basis. Under paragraph 
(d)(1) of this section, P's basis in S's stock is decreased by $100 
(the fair market value of the P stock) because the P stock purchased 
by S and used in the transaction is consideration not provided by P.
    (g) Appreciated asset provided by S. The facts are the same as 
in paragraph (a) of this Example 1, except that P has owned the 
stock of S for several years, and the shareholders of T receive $60 
of P stock and an asset of S with a $30 adjusted basis and $40 fair 
market value. S recognizes a $10 gain from the asset under section 
1001. Under paragraph (b)(1) of this section, P's basis in S's stock 
is increased by $60 to reflect T's net asset basis. Under paragraph 
(d)(1) of this section, P's basis in S's stock is decreased by $40 
(the fair market value of the asset provided by S). In addition, P's 
basis in S's stock is increased under Sec. 1.1502-32(b) by S's $10 
gain.
    (h) Depreciated asset provided by S. The facts are the same as 
in paragraph (a) of this Example 1, except that P has owned the 
stock of S for several years, and the shareholders of T receive $60 
of P stock and an asset of S with a $50 adjusted basis and $40 fair 
market value. S recognizes a $10 loss from the asset under section 
1001. Under paragraph (b)(1) of this section, P's basis in S's stock 
is increased by $60 to reflect T's net asset basis. Under paragraph 
(d)(1) of this section, P's basis in S's stock is decreased by $40 
(the fair market value of the asset provided by S). In addition, S's 
$10 loss is taken into account under Sec. 1.1502-32(b) in 
determining P's basis adjustments under that section.
    Example 2. Stock acquisition. (a) Facts. P is the common parent 
of one group and T is the common parent of another. T has assets 
with an aggregate basis of $60 and fair market value of $100 and no 
liabilities. T's shareholders have an aggregate basis of $50 in T's 
stock. Pursuant to a plan, P forms S and S acquires all of T's stock 
in exchange for P stock in a transaction described in section 
368(a)(1)(B). The transaction is also a reverse acquisition under 
Sec. 1.1502-75(d)(3). Thus, the transaction is a group structure 
change under Sec. 1.1502-33(f)(1), and the earnings and profits of P 
and S are adjusted to reflect T's earnings and profits immediately 
before T ceases to be the common parent of the T group.
    (b) Analysis. Under paragraph (d)(4) of this section, although S 
is not the new common parent of the T group, adjustments must be 
made to S's basis in T's stock in accordance with the principles of 
this section. Although S's basis in T's stock would ordinarily be 
determined under section 362 by reference to the basis of T's 
shareholders in T's stock immediately before the group structure 
change, under the principles of paragraph (b)(2) of this section, 
S's basis in T's stock is determined by reference to T's net asset 
basis. Thus, S's basis in T's stock is $60.
    (c) Higher-tier adjustments. Under paragraph (d)(4) of this 
section, P's basis in S's stock is adjusted to $60 (to be consistent 
with the adjustment to S's basis in T's stock).
    (d) Cross ownership. The facts are the same as in paragraph (a) 
of this Example 2, except that S has owned 10% of T's stock for 
several years and, pursuant to the plan, S acquires the remaining 
90% of T's stock in exchange for P stock. The results are the same 
as in paragraphs (b) and (c) of this Example 2, because S's basis in 
the initial 10% of T's stock is redetermined under this section.
    (e) Allocable share. The facts are the same as in paragraph (a) 
of this Example 2, except that P owns only 90% of S's stock 
immediately after the group structure change. S's basis in T's stock 
is the same as in paragraph (b) of this Example 2. Under paragraph 
(d)(2) of this section, P's basis in its S stock is adjusted to $54 
(90% of S's $60 adjustment).
    Example 3. Taxable stock acquisition. (a) Facts. P is the common 
parent of one group and T is the common parent of another. T has 
assets with an aggregate basis of $60 and fair market value of $100 
and no liabilities. T's shareholders have an aggregate basis of $50 
in T's stock. Pursuant to a plan, P acquires all of T's stock in 
exchange for $70 of P's stock and $30 in a transaction that is a 
group structure change under Sec. 1.1502-33(f)(1). P's acquisition 
of T's stock is a taxable transaction. (Because of P's use of cash, 
the acquisition is not a transaction described in section 
368(a)(1)(B).)
    (b) Analysis. Under paragraph (b)(2) of this section, P's basis 
in T's stock is adjusted to reflect T's net asset basis. Thus, 
although P's basis in T's stock would ordinarily be a cost basis of 
$100, P's basis in T's stock under this section is $60.

    (h) Effective date--(1) General rule. This section applies to group 
structure changes occurring in consolidated return years beginning on 
or after January 1, 1995.
    (2) Prior law. For prior years, see prior regulations under section 
1502 as in effect with respect to the transaction. See, e.g., 
Sec. 1.1502-31T as contained in the 26 CFR part 1 edition revised as of 
April 1, 1994.


Sec. 1.1502-31T  [Removed]

    Par. 12. Section 1.1502-31T is removed.
    Par. 13. Section 1.1502-32 is revised to read as follows:


Sec. 1.1502-32  Investment adjustments.

    (a) In general--(1) Purpose. This section provides rules for 
adjusting the basis of the stock of a subsidiary (S) owned by another 
member (P). These rules modify the determination of P's basis in S's 
stock under applicable rules of law by adjusting P's basis to reflect 
S's distributions and S's items of income, gain, deduction, and loss 
taken into account for the period that S is a member of the 
consolidated group. The purpose of the adjustments is to treat P and S 
as a single entity so that consolidated taxable income reflects the 
group's income. For example, if P forms S with a $100 contribution, and 
S takes into account $10 of income, P's $100 basis in S's stock under 
section 358 is increased by $10 under this section to prevent S's 
income from being taken into account a second time on P's disposition 
of S's stock. Comparable adjustments are made for tax-exempt income and 
noncapital, nondeductible expenses that S takes into account, to 
preserve their treatment under the Internal Revenue Code.
    (2) Application of other rules of law. The rules of this section 
are in addition to other rules of law. See, e.g., section 358 (basis 
determinations for distributees), section 1016 (adjustments to basis), 
Sec. 1.1502-11(b) (limitations on the use of losses), Sec. 1.1502-19 
(treatment of excess loss accounts), Sec. 1.1502-20 (additional rules 
relating to stock loss), and Sec. 1.1502-31 (basis after a group 
structure change). P's basis in S's stock must not be adjusted under 
this section and other rules of law in a manner that has the effect of 
duplicating an adjustment. See also paragraph (h)(5) of this section 
for basis reductions applicable to certain former subsidiaries.
    (3) Overview--(i) In general. The amount of the stock basis 
adjustments and their timing are determined under paragraph (b) of this 
section. Under paragraph (c) of this section, the amount of the 
adjustment is allocated among the shares of S's stock. Paragraphs (d) 
through (g) of this section provide definitions, an anti-avoidance 
rule, successor rules, and recordkeeping requirements.
    (ii) Excess loss account. Negative adjustments under this section 
may exceed P's basis in S's stock. The resulting negative amount is P's 
excess loss account in S's stock. See Sec. 1.1502-19 for rules treating 
excess loss accounts as negative basis, and treating references to 
stock basis as including references to excess loss accounts.
    (iii) Tiering up of adjustments. The adjustments to S's stock under 
this section are taken into account in determining adjustments to 
higher-tier stock. The adjustments are applied in the order of the 
tiers, from the lowest to the highest. For example, if P is also a 
subsidiary, P's adjustment to S's stock is taken into account in 
determining the adjustments to stock of P owned by other members.
    (b) Stock basis adjustments--(1) Timing of adjustments--(i) In 
general. Adjustments under this section are made as of the close of 
each consolidated return year, and as of any other time (an interim 
adjustment) if a determination at that time is necessary to determine a 
tax liability of any person. For example, adjustments are made as of 
P's sale of S's stock in order to measure P's gain or loss from the 
sale, and if P's interest in S's stock is not uniform throughout the 
year (e.g., because P disposes of a portion of its S stock, or S issues 
additional shares to another person), the adjustments under this 
section are made by taking into account the varying interests. An 
interim adjustment may be necessary even if tax liability is not 
affected until a later time. For example, if P sells only 50% of S's 
stock and S becomes a nonmember, adjustments must be made for the 
retained stock as of the disposition (whether or not P has an excess 
loss account in that stock). Similarly, if S liquidates during a 
consolidated return year, adjustments must be made as of the 
liquidation (even if the liquidation is tax free under section 332).
    (ii) Allocation of items. If Sec. 1.1502-76(b) applies to S for 
purposes of an adjustment before the close of the group's consolidated 
return year, the amount of the adjustment is determined under that 
section. If Sec. 1.1502-76(b) does not apply to the interim adjustment, 
the adjustment is determined under the principles of Sec. 1.1502-76(b), 
consistently applied, and ratable allocation under the principles of 
Sec. 1.1502-76(b)(2)(ii) or (iii) may be used without filing an 
election under Sec. 1.1502-76(b)(2). The principles would apply, for 
example, if P becomes a nonmember but S remains a member.
    (2) Amount of adjustments. P's basis in S's stock is increased by 
positive adjustments and decreased by negative adjustments under this 
paragraph (b)(2). The amount of the adjustment, determined as of the 
time of the adjustment, is the net amount of S's--
    (i) Taxable income or loss;
    (ii) Tax-exempt income;
    (iii) Noncapital, nondeductible expenses; and
    (iv) Distributions with respect to S's stock.
    (3) Operating rules. For purposes of determining P's adjustments to 
the basis of S's stock under paragraph (b)(2) of this section--
    (i) Taxable income or loss. S's taxable income or loss is 
consolidated taxable income (or loss) determined by including only S's 
items of income, gain, deduction, and loss taken into account in 
determining consolidated taxable income (or loss), treating S's 
deductions and losses as taken into account to the extent they are 
absorbed by S or any other member. For this purpose:
    (A) To the extent that S's deduction or loss is absorbed in the 
year it arises or is carried forward and absorbed in a subsequent year 
(e.g., under section 172, 465, or 1212), the deduction or loss is taken 
into account under paragraph (b)(2) of this section in the year in 
which it is absorbed.
    (B) To the extent that S's deduction or loss is carried back and 
absorbed in a prior year (whether consolidated or separate), the 
deduction or loss is taken into account under paragraph (b)(2) of this 
section in the year in which it arises and not in the year in which it 
is absorbed.
    (ii) Tax-exempt income--(A) In general. S's tax-exempt income is 
its income and gain which is taken into account but permanently 
excluded from its gross income under applicable law, and which 
increases, directly or indirectly, the basis of its assets (or an 
equivalent amount). For example, S's dividend income to which 
Sec. 1.1502-14(a) applies, and its interest excluded from gross income 
under section 103, are treated as tax-exempt income. However, S's 
income not recognized under section 1031 is not treated as tax- exempt 
income because the corresponding basis adjustments under section 
1031(d) prevent S's nonrecognition from being permanent. Similarly, S's 
tax-exempt income does not include gain not recognized under section 
332 from the liquidation of a lower-tier subsidiary, or not recognized 
under section 118 or section 351 from a transfer of assets to S.
    (B) Equivalent deductions. To the extent that S's taxable income or 
gain is permanently offset by a deduction or loss that does not reduce, 
directly or indirectly, the basis of S's assets (or an equivalent 
amount), the income or gain is treated as tax-exempt income and is 
taken into account under paragraph (b)(3)(ii)(A) of this section. In 
addition, the income and the offsetting item are taken into account 
under paragraph (b)(3)(i) of this section. For example, if S receives a 
$100 dividend with respect to which a $70 dividends received deduction 
is allowed under section 243, $70 of the dividend is treated as tax-
exempt income. Accordingly, P's basis in S's stock increases by $100 
because the $100 dividend and $70 deduction are taken into account 
under paragraph (b)(3)(i) of this section (resulting in $30 of the 
increase), and $70 of the dividend is also taken into account under 
paragraph (b)(3)(ii)(A) of this section as tax-exempt income (resulting 
in $70 of the increase). (See paragraph (b)(3)(iii) of this section if 
there is a corresponding negative adjustment under section 1059.) 
Similarly, income from mineral properties is treated as tax-exempt 
income to the extent it is offset by deductions for depletion in excess 
of the basis of the property.
    (C) Discharge of indebtedness income--(1) In general. Discharge of 
indebtedness income of S that is excluded from gross income under 
section 108 is treated as tax-exempt income only to the extent the 
discharge is applied to reduce tax attributes (e.g., under section 108 
or 1017). Discharge of S's indebtedness is treated as applied to reduce 
tax attributes only to the extent the attribute reduction is taken into 
account as a reduction under paragraph (b)(3)(iii) of this section.
    (2) Expired loss carryovers. If the amount of the discharge exceeds 
the amount of the attribute reduction, the excess is nevertheless 
treated as applied to reduce tax attributes to the extent a loss 
carryover expired without tax benefit, the expiration was taken into 
account as a noncapital, nondeductible expense under paragraph 
(b)(3)(iii) of this section, and the loss carryover would have been 
reduced had it not expired.
    (D) Basis shifts. An increase in the basis of S's assets (or an 
equivalent as described in paragraph (b)(3)(iv)(B) of this section) is 
treated as tax-exempt income to the extent that the increase is not 
otherwise taken into account in determining stock basis, it corresponds 
to a negative adjustment that is taken into account by the group under 
this paragraph (b) (or incurred by the common parent), and it has the 
effect (viewing the group in the aggregate) of a permanent recovery of 
the reduction. For example, S's basis increase under section 50(c)(2) 
is treated as tax-exempt income to the extent the preceding basis 
reduction under section 50(c)(1) is reflected in the basis of a 
member's stock. On the other hand, if S increases the basis of an asset 
as the result of an accounting method change, and the related positive 
section 481(a) adjustment is taken into account over time, the basis 
increase is not treated as tax-exempt income.
    (iii) Noncapital, nondeductible expenses--(A) In general. S's 
noncapital, nondeductible expenses are its deductions and losses that 
are taken into account but permanently disallowed or eliminated under 
applicable law in determining its taxable income or loss, and that 
decrease, directly or indirectly, the basis of its assets (or an 
equivalent amount). For example, S's Federal taxes described in section 
275 and loss not recognized under section 311(a) are noncapital, 
nondeductible expenses. Similarly, if a loss carryover (e.g., under 
section 172 or 1212) attributable to S expires or is reduced under 
section 108(b), it becomes a noncapital, nondeductible expense at the 
close of the last tax year to which it may be carried. However, if S 
sells and repurchases a security subject to section 1091, the 
disallowed loss is not a noncapital, nondeductible expense because the 
corresponding basis adjustments under section 1091(d) prevent the 
disallowance from being permanent.
    (B) Nondeductible basis recovery. Any other decrease in the basis 
of S's assets (or an equivalent as described in paragraph (b)(3)(iv)(B) 
of this section) may be a noncapital, nondeductible expense to the 
extent that the decrease is not otherwise taken into account in 
determining stock basis and is permanently eliminated for purposes of 
determining S's taxable income or loss. Whether a decrease is so 
treated is determined by taking into account both the purposes of the 
Code or regulatory provision resulting in the decrease and the purposes 
of this section. For example, S's noncapital, nondeductible expenses 
include any basis reduction under section 50(c)(1), section 1017, 
section 1059, Sec. 1.1502-20(b), or Sec. 1.1502-20(g). Also included as 
a noncapital, nondeductible expense is the amount of any gross-up for 
taxes paid by another taxpayer that S is treated as having paid (e.g., 
income included under section 78, or the portion of an undistributed 
capital gain dividend that is treated as tax deemed to have been paid 
by a shareholder under section 852(b)(3)(D)(ii), whether or not any 
corresponding amount is claimed as a tax credit). In contrast, a 
decrease generally is not a noncapital, nondeductible expense if it 
results because S redeems stock in a transaction to which section 
302(a) applies, S receives assets in a liquidation to which section 332 
applies and its basis in the assets is less than its basis in the stock 
canceled, or S distributes the stock of a subsidiary in a distribution 
to which section 355 applies.
    (iv) Special rules for tax-exempt income and noncapital, 
nondeductible expenses. For purposes of paragraphs (b)(3)(ii) and (iii) 
of this section:
    (A) Treatment as permanent. An amount is permanently excluded from 
gross income, or permanently disallowed or eliminated, if it is so 
treated by S even though another person may take a corresponding amount 
into account. For example, if S sells property to a nonmember at a loss 
that is disallowed under section 267(a), S's loss is a noncapital, 
nondeductible expense even though under section 267(d) the nonmember 
may treat a corresponding amount of gain as not recognized. (If the 
nonmember is a subsidiary in another consolidated group, its gain not 
recognized under section 267(d) is tax-exempt income under paragraph 
(b)(3)(ii)(A) of this section.)
    (B) Amounts equivalent to basis and adjustments to basis. Amounts 
equivalent to basis include the amount of money, the amount of a loss 
carryover, and the amount of an adjustment to gain or loss under 
section 475(a) for securities described in section 475(a)(2). An 
equivalent to a basis increase includes a decrease in an excess loss 
account, and an equivalent to a basis decrease includes the denial of 
basis for taxable income.
    (C) Timing. An amount is taken into account in the year in which it 
would be taken into account under paragraph (b)(3)(i) of this section 
if it were subject to Federal income taxation.
    (D) Tax sharing agreements. Taxes are taken into account by 
applying the principles of section 1552 and the percentage method under 
Sec. 1.1502-33(d)(3) (and by assuming a 100% allocation of any 
decreased tax liability). The treatment of amounts allocated under this 
paragraph (b)(3)(iv)(D) is analogous to the treatment of allocations 
under Sec. 1.1552-1(b)(2). For example, if one member owes a payment to 
a second member, the first member is treated as indebted to the second 
member. The right to receive payment is treated as a positive 
adjustment under paragraph (b)(3)(ii) of this section, and the 
obligation to make payment is treated as a negative adjustment under 
paragraph (b)(3)(iii) of this section. If the obligation is not paid, 
the amount not paid generally is treated as a distribution, 
contribution, or both, depending on the relationship between the 
members.
    (v) Distributions. Distributions taken into account under paragraph 
(b)(2) of this section are distributions with respect to S's stock to 
which section 301 applies and all other distributions treated as 
dividends (e.g., under section 356(a)(2)). See Sec. 1.1502-14(a)(5) for 
taking into account distributions to which section 301 applies (but not 
other distributions treated as dividends) under the entitlement rule.
    (4) Waiver of loss carryovers from separate return limitation 
years--(i) General rule. If S has a loss carryover from a separate 
return limitation year when it becomes a member of a consolidated 
group, the group may make an irrevocable election to treat all or any 
portion of the loss carryover as expiring for all Federal income tax 
purposes immediately before S becomes a member of the consolidated 
group (deemed expiration). If S was a member of another group 
immediately before it became a member of the consolidated group, the 
expiration is also treated as occurring immediately after it ceases to 
be a member of the prior group.
    (ii) Stock basis adjustments from a waiver--(A) Qualifying 
transactions. If S becomes a member of the consolidated group in a 
qualifying cost basis transaction and an election under this paragraph 
(b)(4) is made, the noncapital, nondeductible expense resulting from 
the deemed expiration does not result in a corresponding stock basis 
adjustment for any member under this section. A qualifying cost basis 
transaction is the purchase (i.e., a transaction in which basis is 
determined under section 1012) by members of the acquiring consolidated 
group (while they are members) in a 12-month period of an amount of S's 
stock satisfying the requirements of section 1504(a)(2).
    (B) Nonqualifying transactions. If S becomes a member of the 
consolidated group other than in a qualifying cost basis transaction 
and an election under this paragraph (b)(4) is made, the basis of its 
stock that is owned by members immediately after it becomes a member is 
subject to reduction under the principles of this section to reflect 
the deemed expiration. The reduction occurs immediately before S 
becomes a member, but after it ceases to be a member of any prior 
group, and it therefore does not result in a corresponding stock basis 
adjustment for any higher-tier member of the transferring or acquiring 
consolidated group. Any basis reduction under this paragraph 
(b)(4)(ii)(B) is taken into account in making determinations of basis 
under the Code with respect to S's stock (e.g., a determination under 
section 362 because the stock is acquired in a transaction described in 
section 368(a)(1)(B)), but it does not result in corresponding stock 
basis adjustments under this section for any higher-tier member. If the 
basis reduction exceeds the basis of S's stock, the excess is treated 
as an excess loss account to which the members owning S's stock 
succeed.
    (C) Higher-tier corporations. If S becomes a member of the 
consolidated group as a result, in whole or in part, of a higher-tier 
corporation becoming a member (whether or not in a qualifying cost 
basis transaction), additional adjustments are required. The highest-
tier corporation (T) whose becoming a member resulted in S becoming a 
member, and T's chain of lower-tier corporations that includes S, are 
subject to the adjustment. The deemed expiration of S's loss carryover 
that results in a negative adjustment for the first higher-tier 
corporation is treated as an expiring loss carryover of that higher-
tier corporation for purposes of applying paragraph (b)(4)(ii)(B) of 
this section to that corporation. For example, if P purchases all of 
the stock of T, T owns all of the stock of T1, T1 owns all of the stock 
of S, S becomes a member as a result of T becoming a member, and the 
election under this paragraph (b)(4) is made, the basis of the S stock 
is reduced and the reduction tiers up to T1, T1 treats the negative 
adjustment to its basis in S's stock as an expiring loss carryover of 
T1, and T then adjusts its basis in T1's stock. In addition, if T 
becomes a member of the acquiring group in a transaction other than a 
qualifying cost basis transaction, the amount that tiers up to T also 
reduces the basis of its stock under paragraph (b)(4)(ii)(B) of this 
section (but the amount does not tier up to higher-tier members).
    (iii) Net asset basis limitation. Basis reduced under this 
paragraph (b)(4) is restored before S becomes a member (and before the 
basis of S's stock is taken into account in determining basis under the 
Code) to the extent necessary to conform a share's basis to its 
allocable portion of net asset basis. In the case of higher-tier 
corporations under paragraph (b)(4)(ii)(C) of this section, the 
restoration does not tier up but is instead applied separately to each 
higher-tier corporation. For purposes of determining each corporation's 
net asset basis (including the basis of stock in lower-tier 
corporations), the restoration is applied in the order of tiers, from 
the lowest to the highest. For purposes of the restoration:
    (A) A member's net asset basis is the positive or negative 
difference between the adjusted basis of its assets (and the amount of 
any of its loss carryovers that are not deemed to expire) and its 
liabilities. Appropriate adjustments must be made, for example, to 
disregard liabilities that subsequently will give rise to deductions 
(e.g., liabilities to which section 461(h) applies).
    (B) Within a class of stock, each share has the same allocable 
portion of net asset basis. If there is more than one class of common 
stock, the net asset basis is allocated to each class by taking into 
account the terms of each class and all other facts and circumstances 
relating to the overall economic arrangement.
    (iv) Election. The election described in this paragraph (b)(4) must 
be made in a separate statement entitled ``ELECTION TO TREAT LOSS 
CARRYOVER AS EXPIRING UNDER Sec. 1.1502-32(b)(4).'' The statement must 
be filed with the consolidated group's return for the year S becomes a 
member, and it must be signed by the common parent and S. A separate 
statement must be made for each member whose loss carryover is deemed 
to expire. The statement must identify the amount of each loss 
carryover deemed to expire (or the amount of each loss carryover deemed 
not to expire, with any balance of any loss carryovers being deemed to 
expire), the basis of any stock reduced as a result of the deemed 
expiration, and the computation of the basis reduction.
    (5) Examples--(i) In general. For purposes of the examples in this 
section, unless otherwise stated, P owns all of the only class of S's 
stock, the stock is owned for the entire year, S owns no stock of 
lower-tier members, the tax year of all persons is the calendar year, 
all persons use the accrual method of accounting, the facts set forth 
the only corporate activity, preferred stock is described in section 
1504(a)(4), all transactions are between unrelated persons, and tax 
liabilities are disregarded.
    (ii) Stock basis adjustments. The principles of this paragraph (b) 
are illustrated by the following examples.

    Example 1. Taxable income. (a) Current taxable income. For Year 
1, the P group has $100 of taxable income when determined by 
including only S's items of income, gain, deduction, and loss taken 
into account. Under paragraph (b)(1) of this section, P's basis in 
S's stock is adjusted under this section as of the close of Year 1. 
Under paragraph (b)(2) of this section, P's basis in S's stock is 
increased by the amount of the P group's taxable income determined 
by including only S's items taken into account. Thus, P's basis in 
S's stock is increased by $100 as of the close of Year 1.
    (b) Intercompany gain that is not taken into account. The facts 
are the same as in paragraph (a) of this Example 1, except that S 
also sells property to another member at a $25 gain in Year 1, the 
gain is deferred under Sec. 1.1502-13 and taken into account in Year 
3, and P sells 10% of S's stock to nonmembers in Year 2. Under 
paragraph (b)(3)(i) of this section, S's deferred gain is not 
additional taxable income for Year 1 or 2 because it is not taken 
into account in determining the P group's consolidated taxable 
income for either of those years. The deferred gain is not tax-
exempt income under paragraph (b)(3)(ii) of this section because it 
is not permanently excluded from S's gross income. The deferred gain 
does not result in a basis adjustment until Year 3, when it is taken 
into account in determining the P group's consolidated taxable 
income. Consequently, P's basis in the S shares sold is not 
increased to reflect S's gain from the intercompany sale of the 
property. In Year 3, the deferred gain is taken into account, but 
the amount allocable to the shares sold by P does not increase their 
basis because these shares are held by nonmembers.
    (c) Intercompany gain taken into account. The facts are the same 
as in paragraph (b) of this Example 1, except that P sells all of 
S's stock in Year 2 (rather than only 10%). Under Sec. 1.1502-13, S 
takes the $25 gain into account immediately before S becomes a 
nonmember. Thus, P's basis in S's stock is increased to reflect S's 
gain from the intercompany sale of the property.
    Example 2. Tax loss. (a) Current absorption. For Year 2, the P 
group has a $50 consolidated net operating loss when determined by 
taking into account only S's items of income, gain, deduction, and 
loss. S's loss is absorbed by the P group in Year 2, offsetting P's 
income for that year. Under paragraph (b)(3)(i)(A) of this section, 
because S's loss is absorbed in the year it arises, P has a $50 
negative adjustment with respect to S's stock. Under paragraph 
(b)(2) of this section, P reduces its basis in S's stock by $50. 
Under paragraph (a)(3)(ii) of this section, if the decrease exceeds 
P's basis in S's stock, the excess is P's excess loss account in S's 
stock.
    (b) Interim determination from stock sale. The facts are the 
same as in paragraph (a) of this Example 2, except that S's Year 2 
loss arises in the first half of the calendar year, P sells 50% of 
S's stock on July 1 of Year 2, and P's income for Year 2 does not 
arise until after the sale of S's stock. P's income for Year 2 
(exclusive of the sale of S's stock) is offset by S's loss, even 
though the income arises after the stock sale, and no loss remains 
to be apportioned to S. See Secs. 1.1502-11 and 1.1502-79. Under 
paragraph (b)(3)(i)(A) of this section, because S's $50 loss is 
absorbed in the year it arises, it reduces P's basis in the S shares 
sold by $25 immediately before the stock sale. Because S becomes a 
nonmember, the loss also reduces P's basis in the retained S shares 
by $25 immediately before S becomes a nonmember. See also 
Sec. 1.1502-20(b) (possible stock basis reduction on the 
deconsolidation of S).
    (c) Loss carryback. The facts are the same as in paragraph (a) 
of this Example 2, except that P has no income or loss for Year 2, 
S's $50 loss is carried back and absorbed by the P group in Year 1 
(offsetting the income of P or S), and the P group receives a $17 
tax refund in Year 2 that is paid to S. Under paragraph (b)(3)(i)(B) 
of this section, because the $50 loss is carried back and absorbed 
in Year 1, it is treated as a tax loss for Year 2 (the year in which 
it arises). Under paragraph (b)(3)(ii) of this section, the refund 
is treated as tax-exempt income of S. Under paragraph (b)(3)(iv)(C) 
of this section, the tax- exempt income is taken into account in 
Year 2 because that is the year it would be taken into account under 
S's method of accounting if it were subject to Federal income 
taxation. Thus, under paragraph (b)(2) of this section, P reduces 
its basis in S's stock by $33 as of the close of Year 2 (the $50 tax 
loss, less the $17 tax refund).
    (d) Loss carryforward. The facts are the same as in paragraph 
(a) of this Example 2, except that P has no income or loss for Year 
2, and S's loss is carried forward and absorbed by the P group in 
Year 3 (offsetting the income of P or S). Under paragraph 
(b)(3)(i)(A) of this section, the loss is not treated as a tax loss 
under paragraph (b)(2) of this section until Year 3.
    Example 3. Tax-exempt income and noncapital, nondeductible 
expenses. (a) Facts. For Year 1, the P group has $500 of 
consolidated taxable income. However, the P group has a $100 
consolidated net operating loss when determined by including only 
S's items of income, gain, deduction, and loss taken into account. 
Also for Year 1, S has $80 of interest income that is permanently 
excluded from gross income under section 103, and S incurs $60 of 
related expense for which a deduction is permanently disallowed 
under section 265.
    (b) Analysis. Under paragraph (b)(3)(i)(A) of this section, S 
has a $100 tax loss for Year 1. Under paragraph (b)(3)(ii)(A) of 
this section, S has $80 of tax-exempt income. Under paragraph 
(b)(3)(iii)(A) of this section, S has $60 of noncapital, 
nondeductible expense. Under paragraph (b)(3)(iv)(C) of this 
section, the tax-exempt income and noncapital, nondeductible expense 
are taken into account in Year 1 because that is the year they would 
be taken into account under S's method of accounting if they were 
subject to Federal income taxation. Thus, under paragraph (b) of 
this section, P reduces its basis in S's stock as of the close of 
Year 1 by an $80 net amount (the $100 tax loss, less $80 of tax-
exempt income, plus $60 of noncapital, nondeductible expenses).
    Example 4. Discharge of indebtedness. (a) Facts. P forms S on 
January 1 of Year 1 and S borrows $200. During Year 1, S's assets 
decline in value and the P group has a $100 consolidated net 
operating loss when determined by including only S's items of 
income, gain, deduction, and loss taken into account. None of the 
loss is absorbed by the group in Year 1, and S is discharged from 
$100 of indebtedness at the close of Year 1. Under section 108(a), 
S's $100 of discharge of indebtedness income is excluded from gross 
income because of insolvency. Under section 108(b), S's $100 net 
operating loss is reduced to zero at the close of Year 1.
    (b) Analysis. Under paragraph (b)(3)(iii)(B) of this section, 
the reduction of the net operating loss is treated as a noncapital, 
nondeductible expense in Year 1 because the net operating loss is 
permanently disallowed by section 108(b). Under paragraph 
(b)(3)(ii)(C) of this section, all $100 of S's discharge of 
indebtedness income is treated as tax-exempt income in Year 1 
because the discharge results in a $100 reduction to S's net 
operating loss. Consequently, the loss and the cancellation of the 
indebtedness result in no net adjustment to P's basis in S's stock 
under paragraph (b) of this section. (If the basis of assets were 
reduced under section 1017, rather than S's loss, the reduction 
would not occur until the beginning of Year 2 and the discharge 
would not be treated as tax-exempt income until that time.)
    (c) Insufficient attributes. The facts are the same as in 
paragraph (a) of this Example 4, except that $70 of S's net 
operating loss is absorbed in Year 1, offsetting P's income for that 
year, and the indebtedness is discharged at the beginning of Year 2. 
Under paragraph (b) of this section, the $70 of S's loss absorbed in 
Year 1 reduces P's basis in S's stock by $70 as of the close of Year 
1. Under section 108(a), S's discharge of indebtedness income in 
Year 2 is excluded from the P group's gross income because of 
insolvency. Under section 108(b), the remaining $30 of S's net 
operating loss carryover from Year 1 is reduced to zero at the close 
of Year 2. No other attributes are reduced. Under paragraph 
(b)(3)(iii)(B) of this section, the elimination of the remaining $30 
net operating loss by section 108(b) is treated as a noncapital, 
nondeductible expense. Under paragraph (b)(3)(ii)(C) of this 
section, only $30 of the discharge is treated as tax-exempt income 
because only that amount is applied to reduce tax attributes. See 
also Sec. 1.1502-19(c)(1)(iii) (taking into account any excess loss 
account of P in S's stock). The remaining $70 of discharge income 
excluded under section 108(a) has no effect on P's basis in S's 
stock.
    (d) Purchase price adjustment. Assume instead that S buys land 
in Year 1 in exchange for S's $100 purchase money note (bearing 
interest at a market rate of interest in excess of the applicable 
Federal rate, and providing for a principal payment at the end of 
Year 10), and the seller agrees with S in Year 4 to discharge $60 of 
the note as a purchase price adjustment to which section 108(e)(5) 
applies. S has no discharge of indebtedness income that is treated 
as tax-exempt income under paragraph (b)(3)(ii) of this section. In 
addition, the $60 purchase price adjustment is not a noncapital, 
nondeductible expense under paragraph (b)(3)(iii) of this section. A 
purchase price adjustment is not equivalent to a discharge of 
indebtedness that is offset by a deduction or loss. Consequently, 
the purchase price adjustment results in no net adjustment to P's 
basis in S's stock under paragraph (b) of this section.
    Example 5. Distributions. (a) Amounts declared and distributed. 
For Year 1, the P group has $120 of consolidated taxable income when 
determined by including only S's items of income, gain, deduction, 
and loss taken into account. S declares and makes a $10 dividend 
distribution to P at the close of Year 1. Under paragraph (b) of 
this section, P increases its basis in S's stock as of the close of 
Year 1 by a $110 net amount ($120 of taxable income, less a $10 
distribution).
    (b) Distributions in later years. The facts are the same as in 
paragraph (a) of this Example 5, except that S does not declare and 
distribute the $10 until Year 2. Under paragraph (b) of this 
section, P increases its basis in S's stock by $120 as of the close 
of Year 1, and decreases its basis by $10 as of the close of Year 2. 
(If P were also a subsidiary, the basis of its stock would also be 
increased in Year 1 to reflect P's $120 adjustment to basis of S's 
stock; the basis of P's stock would not be changed as a result of 
S's distribution in Year 2, because P's $10 of tax-exempt dividend 
income under paragraph (b)(3)(ii) of this section would be offset by 
the $10 negative adjustment to P's basis in S's stock for the 
distribution.)
    (c) Amounts declared but not distributed. The facts are the same 
as in paragraph (a) of this Example 5, except that, during December 
of Year 1, S declares (and P becomes entitled to) another $70 
dividend distribution with respect to its stock, but P does not 
receive the distribution until after it sells all of S's stock at 
the close of Year 1. Under Sec. 1.1502-14(a), S is treated as making 
a $70 distribution to P at the time P becomes entitled to the 
distribution. (If S is distributing an appreciated asset, its gain 
under section 311 is also taken into account under paragraph 
(b)(3)(i) of this section at the time P becomes entitled to the 
distribution.) Consequently, under paragraph (b) of this section, P 
increases its basis in S's stock as of the close of Year 1 by only a 
$40 net amount ($120 of taxable income, less two distributions 
totalling $80). Any further adjustments after S ceases to be a 
member and the $70 distribution is made would be duplicative, 
because the stock basis has already been adjusted for the 
distribution. Accordingly, the distribution will not result in 
further adjustments or gain, even if the distribution is a payment 
to which section 301(c)(2) or (3) applies.
    Example 6. Reorganization with boot. (a) Facts. P owns all of 
the stock of S and T. On January 1 of Year 1, P has a $100 basis in 
the S stock and a $60 basis in the T stock. S and T have no items of 
income, gain, deduction, or loss for Year 1. S and T each have 
substantial earnings and profits. At the close of Year 1, T merges 
into S in a reorganization described in section 368(a)(1)(A) (and in 
section 368(a)(1)(D)). P receives no additional S stock, but does 
receive $10 which is treated as a dividend under section 356(a)(2).
    (b) Analysis. Under section 358, P's basis in the S stock is 
increased by its basis in the T stock, decreased to reflect the 
money received, and increased to reflect treatment of the money as a 
dividend. Under paragraph (b)(3)(v) of this section, the $10 is also 
treated as a distribution to which paragraph (b)(2)(iv) of this 
section applies. Thus, under section 358 and paragraph (b) of this 
section, P's basis in the S stock is $150 immediately after the 
merger. (If there had been insufficient earnings and profits to 
treat the $10 as a dividend under section 356(a)(2), P's basis in 
the S stock would be $160 because the $10 would not be a 
distribution to which section 301 applies; but see Sec. 1.1502-13 
for the deferral and taking into account of P's $10 gain under 
section 356(a)(1).)
    Example 7. Tiering up of basis adjustments. P owns all of S's 
stock, and S owns all of T's stock. For Year 1, the P group has $100 
of consolidated taxable income when determined by including only T's 
items of income, gain, deduction, and loss taken into account, and 
$50 of consolidated taxable income when determined by including only 
S's items taken into account. S increases its basis in T's stock by 
$100 under paragraph (b) of this section. Under paragraph (a)(3) of 
this section, this $100 basis adjustment is taken into account in 
determining P's adjustments to its basis in S's stock. Thus, P 
increases its basis in S's stock by $150 under paragraph (b) of this 
section.
    Example 8. Allocation of items. (a) Acquisition in mid-year. P 
is the common parent of a consolidated group, and S is an 
unaffiliated corporation filing separate returns on a calendar-year 
basis. P acquires all of S's stock and S becomes a member of the P 
group on July 1 of Year 1. For the entire calendar Year 1, S has 
$100 of ordinary income and under Sec. 1.1502-76(b) $60 is allocated 
to the period from January 1 to June 30 and $40 to the period from 
July 1 to December 31. Under paragraph (b) of this section, P 
increases its basis in S's stock by $40.
    (b) Sale in mid-year. The facts are the same as in paragraph (a) 
of this Example 8, except that S is a member of the P group at the 
beginning of Year 1 but ceases to be a member on June 30 as a result 
of P's sale of S's stock. Under paragraph (b) of this section, P 
increases its basis in S's stock by $60 immediately before the stock 
sale. (P's basis increase would be the same if S became a nonmember 
because S issued additional shares to nonmembers.)
    (c) Absorption of loss carryovers. Assume instead that S is a 
member of the P group at the beginning of Year 1 but ceases to be a 
member on June 30 as a result of P's sale of S's stock, and a $100 
consolidated net operating loss attributable to S is carried over by 
the P group to Year 1. The consolidated net operating loss may be 
apportioned to S for its first separate return year only to the 
extent not absorbed by the P group during Year 1. Under paragraph 
(b)(3)(i) of this section, if the loss is absorbed by the P group in 
Year 1, whether the offsetting income arises before or after P's 
sale of S's stock, the absorption of the loss carryover is included 
in the determination of S's taxable income or loss for Year 1. Thus, 
P's basis in S's stock is adjusted under paragraph (b) of this 
section to reflect any absorption of the loss by the P group.
    Example 9. Gross-ups. (a) Facts. P owns all of the stock of S, 
and S owns all of the stock of T, a newly formed controlled foreign 
corporation that is not a passive foreign investment company. In 
Year 1, T has $100 of subpart F income and pays $34 of foreign 
income tax, leaving T with $66 of earnings and profits. The P group 
has $100 of consolidated taxable income when determined by taking 
into account only S's items (the inclusion under section 951(a), 
taking into account the section 78 gross-up). As a result of the 
section 951(a) inclusion, S increases its basis in T's stock by $66 
under section 961(a).
    (b) Analysis. Under paragraph (b)(3)(i) of this section, S has 
$100 of taxable income. Under paragraph (b)(3)(iii)(B) of this 
section, the $34 gross-up for taxes paid by T that S is treated as 
having paid is a noncapital, nondeductible expense (whether or not 
any corresponding amount is claimed by the P group as a tax credit). 
Thus, P increases its basis in S's stock under paragraph (b) of this 
section by the net adjustment of $66.
    (c) Subsequent distribution. The facts are the same as in 
paragraph (a) of this Example 9, except that T distributes its $66 
of earnings and profits in Year 2. The $66 distribution received by 
S is excluded from S's income under section 959(a) because the 
distribution represents earnings and profits attributable to amounts 
that were included in S's income under section 951(a) for Year 1. In 
addition, S's basis in T's stock is decreased by $66 under section 
961(b). The excluded distribution is not tax-exempt income under 
paragraph (b)(3)(ii) of this section because of the corresponding 
reduction to S's basis in T's stock. Consequently, P's basis in S's 
stock is not adjusted under paragraph (b) of this section for Year 
2.
    Example 10. Recapture of tax-exempt items. (a) Facts. S is a 
life insurance company. For Year 1, the P group has $200 of 
consolidated taxable income, determined by including only S's items 
of income, gain, deduction, and loss taken into account (including a 
$300 small company deduction under section 806). In addition, S has 
$100 of tax-exempt interest income, $60 of which is S's company 
share. The remaining $40 of tax-exempt income is the policyholders' 
share that reduces S's deduction for increase in reserves.
    (b) Tax-exempt items generally. Under paragraph (b)(3)(i) of 
this section, S has $200 of taxable income for Year 1. Also for Year 
1, S has $100 of tax-exempt income under paragraph (b)(3)(ii)(A) of 
this section, and another $300 is treated as tax-exempt income under 
paragraph (b)(3)(ii)(B) of this section because of the deduction 
under section 806. Under paragraph (b)(3)(iii) of this section, S 
has $40 of noncapital, nondeductible expenses for Year 1 because S's 
deduction under section 807 for its increase in reserves has been 
permanently reduced by the $40 policyholders' share of the tax-
exempt interest income. Thus, P increases its basis in S's stock by 
$560 under paragraph (b) of this section.
    (c) Recapture. Assume instead that S is a property and casualty 
company and, for Year 1, S accrues $100 of estimated salvage 
recoverable under section 832. Of this amount, $87 (87% of $100) is 
excluded from gross income because of the ``fresh start'' provisions 
of Sec. 11305(c) of P.L. 101-508 (the Omnibus Budget Reconciliation 
Act of 1990). Thus, S has $87 of tax-exempt income under paragraph 
(b)(3)(ii)(A) of this section that increases P's basis in S's stock 
for Year 1. (S also has $13 of taxable income over the period of 
inclusion under section 481.) In Year 5, S determines that the $100 
salvage recoverable was overestimated by $30 and deducts $30 for the 
reduction of the salvage recoverable. However, S has $26.10 (87% of 
$30) of taxable income in Year 5 due to the partial recapture of its 
fresh start. Because S has no basis corresponding to this income, S 
is treated under paragraph (b)(3)(iii)(B) of this section as having 
a $26.10 noncapital, nondeductible expense in Year 5. This treatment 
is necessary to reflect the elimination of the erroneous fresh start 
in S's stock basis and causes a decrease in P's basis in S's stock 
by $30 for Year 5 (a $3.90 taxable loss and a $26.10 special 
adjustment).

    (c) Allocation of adjustments among shares of stock--(1) In 
general. The portion of the adjustment under paragraph (b) of this 
section that is described in paragraph (b)(2)(iv) of this section 
(negative adjustments for distributions) is allocated to the shares of 
S's stock to which the distribution relates. The remainder of the 
adjustment, described in paragraphs (b)(2)(i) through (iii) of this 
section (adjustments for taxable income or loss, tax-exempt income, and 
noncapital, nondeductible expenses), is allocated among the shares of 
S's stock as provided in paragraphs (c)(2) through (4) of this section. 
If the remainder of the adjustment is positive, it is allocated first 
to any preferred stock to the extent provided in paragraph (c)(3) of 
this section, and then to the common stock as provided in paragraph 
(c)(2) of this section. If the remainder of the adjustment is negative, 
it is allocated only to common stock as provided in paragraph (c)(2) of 
this section. An adjustment under this section allocated to a share for 
the period the share is owned by a nonmember has no effect on the basis 
of the share. See paragraph (c)(4) of this section for the reallocation 
of adjustments, and paragraph (d) of this section for definitions. See 
Sec. 1.1502-19(d) for special allocations of basis determined or 
adjusted under the Code with respect to excess loss accounts.
    (2) Common stock--(i) Allocation within a class. The portion of the 
adjustment described in paragraphs (b)(2)(i) through (iii) of this 
section (the adjustment determined without taking distributions into 
account) that is allocable to a class of common stock is generally 
allocated equally to each share within the class. However, if a member 
has an excess loss account in shares of a class of common stock at the 
time of a positive adjustment, the portion of the adjustment allocable 
to the member with respect to the class is allocated first to equalize 
and eliminate that member's excess loss accounts and then to increase 
equally its basis in the shares of that class. Similarly, any negative 
adjustment is allocated first to reduce the member's positive basis in 
shares of the class before creating or increasing its excess loss 
account. Distributions and any adjustments or determinations under the 
Internal Revenue Code (e.g., under section 358, including any 
modifications under Sec. 1.1502-19(d)) are taken into account before 
the allocation is made under this paragraph (c)(2)(i).
    (ii) Allocation among classes--(A) General rule. If S has more than 
one class of common stock, the extent to which the adjustment described 
in paragraphs (b)(2)(i) through (iii) of this section (the adjustment 
determined without taking distributions into account) is allocated to 
each class is determined, based on consistently applied assumptions, by 
taking into account the terms of each class and all other facts and 
circumstances relating to the overall economic arrangement. The 
allocation generally must reflect the manner in which the classes 
participate in the economic benefit or burden (if any) corresponding to 
the items of income, gain, deduction, or loss allocated. In determining 
participation, any differences in voting rights are not taken into 
account, and the following factors are among those to be considered--
    (1) The interest of each share in economic profits and losses (if 
different from the interest in taxable income);
    (2) The interest of each share in cash flow and other non-
liquidating distributions; and
    (3) The interest of each share in distributions in liquidation.
    (B) Distributions and Code adjustments. Distributions and any 
adjustments or determinations under the Internal Revenue Code are taken 
into account before the allocation is made under this paragraph 
(c)(2)(ii).
    (3) Preferred stock. If the adjustment under paragraphs (b)(2)(i) 
through (iii) of this section (the adjustment determined without taking 
distributions into account) is positive, it is allocated to preferred 
stock to the extent required (when aggregated with prior allocations to 
the preferred stock during the period that S is a member of the 
consolidated group) to reflect distributions described in section 301 
(and all other distributions treated as dividends) to which the 
preferred stock becomes entitled, and arrearages arising, during the 
period that S is a member of the consolidated group. For this purpose, 
the preferred stock is treated as entitled to a distribution no later 
than the time the distribution is taken into account under the Internal 
Revenue Code (e.g., under section 305). If the amount of distributions 
and arrearages exceeds the positive amount (when aggregated with prior 
allocations), the positive amount is first allocated among classes of 
preferred stock to reflect their relative priorities, and the amount 
allocated to each class is then allocated pro rata within the class. An 
allocation to a share with respect to arrearages and distributions for 
the period the share is owned by a nonmember is not reflected in the 
basis of the share under paragraph (b) of this section. However, if P 
and S cease to be members of one consolidated group and remain 
affiliated as members of another consolidated group, P's ownership of 
S's stock during consolidated return years of the prior group is 
treated for this purpose as ownership by a member to the extent that 
the adjustments during the prior consolidated return years are still 
reflected in the basis of the preferred stock.
    (4) Cumulative redetermination--(i) General rule. A member's basis 
in each share of S's preferred and common stock must be redetermined 
whenever necessary to determine the tax liability of any person. See 
paragraph (b)(1) of this section. The redetermination is made by 
reallocating S's net adjustment described in paragraphs (b)(2)(i) 
through (iii) of this section (the adjustment determined without taking 
distributions into account) for each consolidated return year (or other 
applicable period) of the group by taking into account all of the facts 
and circumstances affecting allocations under this paragraph (c) as of 
the redetermination date with respect to all of S's shares. For this 
purpose:
    (A) Amounts may be reallocated from one class of S's stock to 
another class, but not from one share of a class to another share of 
the same class.
    (B) If there is a change in the equity structure of S (e.g., as the 
result of S's issuance, redemption, or recapitalization of shares), a 
cumulative redetermination is made for the period before the change. If 
a reallocation is required by another redetermination after a change, 
amounts arising after the change are reallocated before amounts arising 
before the change.
    (C) If S becomes a nonmember as a result of a change in its equity 
structure, any reallocation is made only among the shares of S's stock 
immediately before the change. For example, if S issues stock to a 
nonmember creditor in exchange for its debt, and the exchange results 
in S becoming a nonmember, any reallocation is only among the shares of 
S's stock immediately before the exchange.
    (D) Any reallocation is treated for all purposes after it is made 
(including subsequent redeterminations) as the original allocation of 
an amount under this paragraph (c), but the reallocation does not 
affect any prior period.
    (ii) Prior use of allocations. An amount may not be reallocated 
under paragraph (c)(4)(i) of this section to the extent that the amount 
has been used before the reallocation. For this purpose, an amount has 
been used to the extent it has been taken into account, directly or 
indirectly, by any member in determining income, gain, deduction, or 
loss, or in determining the basis of any property that is not subject 
to this section (e.g., stock of a corporation that has become a 
nonmember). For example, if P sells a share of S stock, an amount 
previously allocated to the share cannot be reallocated to another 
share of S stock, but an amount allocated to another share of S stock 
can still be reallocated to the sold share because the reallocated 
amount has not been taken into account; however, any adjustment 
reallocated to the sold share may effectively be eliminated, because 
the reallocation was not in effect when the share was previously sold 
and P's gain or loss from the sale is not redetermined. If, however, P 
sells the share of S stock to another member, the amount is not used 
until P's gain or loss is taken into account under Sec. 1.1502-13.
    (5) Examples. The principles of this paragraph (c) are illustrated 
by the following examples.

    Example 1. Ownership of less than all the stock. (a) Facts. P 
owns 80% of S's only class of stock with an $800 basis. For Year 1, 
S has $100 of taxable income.
    (b) Analysis. Under paragraph (c)(1) of this section, the $100 
positive adjustment under paragraph (b) of this section for S's 
taxable income is allocated among the shares of S's stock, including 
shares owned by nonmembers. Under paragraph (c)(2)(i) of this 
section, the adjustment is allocated equally to each share of S's 
stock. Thus, P increases its basis in S's stock under paragraph (b) 
of this section as of the close of Year 1 by $80. (The basis of the 
20% of S's stock owned by nonmembers is not adjusted under this 
section.)
    (c) Varying interest. The facts are the same as in paragraph (a) 
of this Example 1, except that P buys the remaining 20% of S's stock 
at the close of business on June 30 of Year 1 for $208. Under 
paragraph (b)(1) of this section and the principles of Sec. 1.1502-
76(b), S's $100 of taxable income is allocable $40 to the period 
from January 1 to June 30 and $60 to the period from July 1 to 
December 31. Thus, for the period ending June 30, P is treated as 
having a $32 adjustment with respect to the S stock that P has owned 
since January 1 (80% of $40) and, under paragraph (c)(2)(i) of this 
section, the adjustment is allocated equally among those shares. For 
the period ending December 31, P is treated as having a $60 
adjustment (100% of $60) that is also allocated equally among P's 
shares of S's stock owned after June 30. P's basis in the shares 
owned as of the beginning of the year therefore increases by $80 
(the sum of 80% of $40 and 80% of $60), from $800 to $880, and P's 
basis in the shares purchased on June 30 increases by $12 (20% of 
$60), from $208 to $220. Thus, P's aggregate basis in S's stock as 
of the end of Year 1 is $1,100.
    (d) Tax liability. The facts are the same as in paragraph (a) of 
this Example 1, except that P pays S's $34 share of the group's 
consolidated tax liability resulting from S's taxable income, and S 
does not reimburse P. S's $100 of taxable income results in a 
positive adjustment under paragraph (b)(3)(i) of this section, and 
S's $34 of tax liability results in a negative adjustment under 
paragraph (b)(3)(iv)(D) of this section and the principles of 
section 1552. Because S does not make any payment in recognition of 
the additional tax liability, by analogy to the treatment under 
Sec. 1.1552-1(b)(2), S is treated as having made a $34 payment that 
is described in paragraph (b)(3)(iii) of this section (noncapital, 
nondeductible expenses) and as having received an equal amount from 
P as a capital contribution. Thus, P increases its basis in its S 
stock by $52.80 (80% of the $100 of taxable income, less 80% of the 
$34 tax payment). In addition, P increases its basis in S's stock by 
$34 under the Internal Revenue Code and paragraph (a)(2) of this 
section to reflect the capital contribution. In the aggregate, P 
increases its basis in S's stock by $86.80. (If, as in paragraph (c) 
of this Example 1, P buys the remaining 20% of S's stock at the 
close of business on June 30, P increases its basis in S's stock by 
another $7.90 for the additional 20% interest in S's income after 
June 30 ($60 multiplied by 20%, less 20% of the $20.40 tax payment 
on $60); the $34 capital contribution by P is reflected in all of 
its S shares (not just the original 80%), and P's aggregate basis 
adjustment under this section is $94.70 ($86.80 plus $7.90).)
    Example 2. Preferred stock. (a) Facts. P owns all of S's common 
stock with an $800 basis, and nonmembers own all of S's preferred 
stock. The preferred stock was issued for $200, has a $20 annual, 
cumulative preference as to dividends, and has an initial 
liquidation preference of $200. For Year 1, S has $50 of taxable 
income and no distributions are declared or made.
    (b) Analysis of arrearages. Under paragraphs (c) (1) and (3) of 
this section, $20 of the $50 positive adjustment under paragraph (b) 
of this section is allocated first to the preferred stock to reflect 
the dividend arrearage arising in Year 1. The remaining $30 of the 
positive adjustment is allocated to the common stock, increasing P's 
basis from $800 to $830 as of the close of Year 1. (The basis of the 
preferred stock owned by nonmembers is not adjusted under this 
section.)
    (c) Current distribution. The facts are the same as in paragraph 
(a) of this Example 2, except that S declares and makes a $20 
distribution with respect to the preferred stock during Year 1 in 
satisfaction of its preference. The results are the same as in 
paragraph (b) of this Example 2. 
    (d) Varying interest. The facts are the same as in paragraph (a) 
of this Example 2, except that S has no income or loss for Years 1 
and 2, P purchases all of S's preferred stock at the beginning of 
Year 3 for $240, and S has $70 of taxable income for Year 3. Under 
paragraph (c)(3) of this section, $60 of the $70 positive adjustment 
under paragraph (b) of this section is allocated to the preferred 
stock to reflect the dividends arrearages for Years 1 through 3, but 
only the $20 for Year 3 is reflected in the basis of the preferred 
stock under paragraph (b) of this section. (The remaining $40 is not 
reflected because the preferred stock was owned by nonmembers during 
Years 1 and 2.) Thus, P increases its basis in S's preferred stock 
from $240 to $260, and its basis in S's common stock from $800 to 
$810, as of the close of Year 3. (If P had acquired all of S's 
preferred stock in a transaction to which section 351 applies, and 
P's initial basis in S's preferred stock was $200 under section 362, 
P's basis in S's preferred stock would increase from $200 to $220.)
    (e) Varying interest with current distributions. The facts are 
the same as in paragraph (d) of this Example 2, except that S 
declares and makes a $20 distribution with respect to the preferred 
stock in each of Years 1 and 2 in satisfaction of its preference, 
and P purchases all of S's preferred stock at the beginning of Year 
3 for $200. Under paragraph (c)(3) of this section, $40 of the $70 
positive adjustment under paragraph (b) of this section is allocated 
to the preferred stock to reflect the distributions in Years 1 and 
2, and $20 of the $70 is allocated to the preferred stock to reflect 
the arrearage for Year 3. However, as in paragraph (d) of this 
Example 2, only the $20 attributable to Year 3 is reflected in the 
basis of the preferred stock under paragraph (b) of this section. 
Thus, P increases its basis in S's preferred stock from $200 to 
$220, and P increases its basis in S's common stock from $800 to 
$810.
    Example 3. Cumulative redetermination. (a) Facts. P owns all of 
S's common and preferred stock. The preferred stock has a $100 
annual, cumulative preference as to dividends. For Year 1, S has 
$200 of taxable income, the first $100 of which is allocated to the 
preferred stock and the remaining $100 of which is allocated to the 
common stock. For Year 2, S has no adjustment under paragraph (b) of 
this section, and P sells all of S's common stock at the close of 
Year 2.
    (b) Analysis. Under paragraph (c)(4) of this section, P's basis 
in S's common stock must be redetermined as of the sale of the 
stock. The redetermination is made by reallocating the $200 positive 
adjustment under paragraph (b) of this section for Year 1 by taking 
into account all of the facts and circumstances affecting 
allocations as of the sale. Thus, the $200 positive adjustment for 
Year 1 is reallocated entirely to the preferred stock to reflect the 
dividend arrearages for Years 1 and 2. The reallocation away from 
the common stock reflects the fact that, because of the additional 
amount of arrearage in Year 2, the common stock is not entitled to 
any part of the $200 of taxable income from Year 1. Thus, the common 
stock has no positive or negative adjustment, and the preferred 
stock has a $200 positive adjustment. These reallocations are 
treated as the original allocations for Years 1 and 2. (The results 
for the common stock would be the same if the common and preferred 
stock were not owned by the same member, or the preferred stock were 
owned by nonmembers.)
    (c) Preferred stock issued after adjustment arises. The facts 
are the same as in paragraph (a) of this Example 3, except that S 
does not issue its preferred stock until the beginning of Year 2, S 
has no further adjustment under paragraph (b) of this section for 
Years 2 and 3, and P sells S's common stock at the close of Year 3. 
Under paragraphs (c) (1) and (2) of this section, the $200 positive 
adjustment for Year 1 is initially allocated entirely to the common 
stock. Under paragraph (c)(4) of this section, the $200 adjustment 
is reallocated to the preferred stock to reflect the arrearages for 
Years 2 and 3. Thus, the common stock has no positive or negative 
adjustment.
    (d) Common stock issued after adjustment arises. The facts are 
the same as in paragraph (a) of this Example 3, except that S has no 
preferred stock, S issues additional common stock of the same class 
at the beginning of Year 2, S has no further adjustment under 
paragraph (b) of this section in Years 2 and 3, and P sells its S 
common stock at the close of Year 3. Under paragraphs (c) (1) and 
(2) of this section, the $200 positive adjustment for Year 1 is 
initially allocated entirely to the original common stock. Under 
paragraph (c)(4)(i)(A) of this section, the $200 adjustment is not 
reallocated among the original common stock and the additional 
stock. Unlike the preferred stock in paragraph (c) of this Example 
3, the additional common stock is of the same class as the original 
stock, and there is no reallocation between shares of the same 
class.
    (e) Positive and negative adjustments. The facts are the same as 
in paragraph (a) of this Example 3, except that S has a $200 loss 
for Year 2 that results in a negative adjustment to the common stock 
before any redetermination. For purposes of the basis 
redetermination under paragraph (c)(4) of this section, the Year 1 
and 2 adjustments under paragraph (b) of this section are not 
netted. Thus, as in paragraph (b) of this Example 3, the 
redetermination is made by reallocating the $200 positive adjustment 
for Year 1 entirely to the preferred stock. The $200 negative 
adjustment for Year 2 is allocated entirely to the common stock. 
Consequently, the preferred stock has a $200 positive cumulative 
adjustment, and the common stock has a $200 negative cumulative 
adjustment. (The results would be the same if there were no other 
adjustments described in paragraph (b) of this section, P sells S's 
common stock at the close of Year 3 rather than Year 2, and an 
additional $100 arrearage arises in Year 3; only adjustments under 
paragraph (b) of this section may be reallocated, and there is no 
additional adjustment for Year 3.)
    (f) Current distributions. The facts are the same as in 
paragraph (a) of this Example 3, except that, during Year 1, S 
declares and makes a distribution to P of $100 as a dividend on the 
preferred stock and $100 as a dividend on the common stock. The 
taxable income and distributions result in no Year 1 adjustment 
under paragraph (b) of this section for either the common or 
preferred stock. However, as in paragraph (b) of this Example 3, the 
redetermination under paragraph (c)(4) of this section is made by 
reallocating a $200 positive adjustment for Year 1 (S's net 
adjustment described in paragraph (b) of this section, determined 
without taking distributions into account) to the preferred stock. 
Consequently, the preferred stock has a $100 positive cumulative 
adjustment ($200 of taxable income, less a $100 distribution with 
respect to the preferred stock) and the common stock has a $100 
negative cumulative adjustment (for the distribution).
    (g) Convertible preferred stock. The facts are the same as in 
paragraph (a) of this Example 3, except that the preferred stock is 
convertible into common stock that is identical to the common stock 
already outstanding, the holders of the preferred stock convert the 
stock at the close of Year 2, and no stock is sold until the close 
of Year 5. Under paragraph (c)(4) of this section, the $200 positive 
adjustment for Year 1 is reallocated entirely to the preferred stock 
immediately before the conversion. The newly issued common stock is 
treated as a second class of S common stock, and adjustments under 
paragraph (b) of this section are allocated between the original and 
the new common stock under paragraph (c)(2)(ii) of this section. 
Although the preferred stock is converted to common stock, the $200 
adjustment to the preferred stock is not subsequently reallocated 
between the original and the new common stock. Because the original 
and the new stock are equivalent, adjustments under paragraph (b) of 
this section for subsequent periods are allocated equally to each 
share.
    (h) Prior use of allocations. The facts are the same as in 
paragraph (a) of this Example 3, except that P sells 10% of S's 
common stock at the close of Year 1, and the remaining 90% at the 
close of Year 2. P's basis in the common stock sold in Year 1 
reflects $10 of the adjustment allocated to the common stock for 
Year 1. Under paragraph (c)(4)(ii) of this section, because $10 of 
the Year 1 adjustment was used in determining P's gain or loss, only 
$90 is reallocated to the preferred stock, and $10 remains allocated 
to the common stock sold.
    (i) Lower-tier members. The facts are the same as in paragraph 
(a) of this Example 3, except that P owns only S's common stock, and 
P is also a subsidiary. If there is a redetermination under 
paragraph (c)(4) of this section by a member owning P's stock, a 
redetermination with respect to S's stock must be made first, and 
the effect of that redetermination on P's adjustments is taken into 
account under paragraph (b) of this section. However, as in 
paragraph (h) of this Example 3, to the extent an amount of the 
initial adjustments with respect to S's common stock have already 
been tiered up and used by a member owning P's stock, that amount 
remains with S's common stock (and the higher-tier member using the 
adjustment with respect to P's stock), and may not be reallocated to 
S's preferred stock.
    Example 4. Allocation to preferred stock between groups. (a) 
Facts. P owns all of S's only class of stock, and S owns all of T's 
common and preferred stock. The preferred stock has a $100 annual, 
cumulative preference as to dividends. For Year 1, T has $200 of 
taxable income, the first $100 of which is allocated to the 
preferred stock and the remaining $100 of which is allocated to the 
common stock, and S has no adjustments other than the amounts tiered 
up from T. S and T have no adjustments under paragraph (b) of this 
section for Years 2 and 3. X, the common parent of another 
consolidated group, purchases all of S's stock at the close of Year 
3, and S and T become members of the X group. For Year 4, T has $200 
of taxable income, and S has no adjustments other than the amounts 
tiered up from T.
    (b) Analysis for Years 1 through 3. Under paragraph (c)(4) of 
this section, the allocation of S's adjustments under paragraph (b) 
of this section (determined without taking distributions into 
account) must be redetermined as of the time P sells S's stock. As a 
result of this redetermination, T's common stock has no positive or 
negative adjustment and the preferred stock has a $200 positive 
adjustment.
    (c) Analysis for Year 4. Under paragraph (c)(3) of this section, 
the allocation of T's $200 positive adjustment in Year 4 to T's 
preferred stock with respect to arrearages is made by taking into 
account the consolidated return years of both the P group and the X 
group. Thus, the allocation of the $200 positive adjustment for Year 
4 to T's preferred stock is not treated as an allocation for a 
period for which the preferred stock is owned by a nonmember. Thus, 
the $200 adjustment is reflected in S's basis in T's preferred stock 
under paragraph (b) of this section.

    (d) Definitions. For purposes of this section--
    (1) Class. The shares of a member having the same material terms 
(without taking into account voting rights) are treated as a single 
class of stock.
    (2) Preferred stock. Preferred stock is stock that is limited and 
preferred as to dividends and has a liquidation preference. A class of 
stock that is not described in section 1504(a)(4), however, is not 
treated as preferred stock for purposes of paragraph (c) of this 
section if members own less than 80% of each class of common stock 
(determined without taking this paragraph (d)(2) into account).
    (3) Common stock. Common stock is stock that is not preferred 
stock.
    (4) Becoming a nonmember. A member is treated as becoming a 
nonmember if it has a separate return year (including another group's 
consolidated return year). For example, S may become a nonmember if it 
issues additional stock to nonmembers, but S does not become a 
nonmember as a result of its complete liquidation.
    (e) Anti-avoidance rule--(1) General rule. If any person acts with 
a principal purpose contrary to the purposes of this section, to avoid 
the effect of the rules of this section or apply the rules of this 
section to avoid the effect of any other provision of the consolidated 
return regulations, adjustments must be made as necessary to carry out 
the purposes of this section.
    (2) Examples. The principles of this paragraph (e) are illustrated 
by the following examples.

    Example 1. Preferred stock treated as common stock. (a) Facts. S 
has 100 shares of common stock and 100 shares of preferred stock 
described in section 1504(a)(4). P owns 80 shares of S's common 
stock and all of S's preferred stock. The shareholders expect that S 
will have negative adjustments under paragraph (b) of this section 
for Years 1 and 2 (all of which will be allocable to S's common 
stock), the negative adjustments will have no significant effect on 
the value of S's stock, and S will have offsetting positive 
adjustments thereafter. When the preferred stock was issued, P 
intended to cause S to recapitalize the preferred stock into 
additional common stock at the end of Year 2 in a transaction 
described in section 368(a)(1)(E). P's temporary ownership of the 
preferred stock is with a principal purpose to limit P's basis 
reductions under paragraph (b) of this section to 80% of the 
anticipated negative adjustments. The recapitalization is intended 
to cause significantly more than 80% of the anticipated positive 
adjustments to increase P's basis in S's stock because of P's 
increased ownership of S's common stock immediately after the 
recapitalization.
    (b) Analysis. S has established a transitory capital structure 
with a principal purpose to enhance P's basis in S's stock under 
this section. Under paragraph (e)(1) of this section, all of S's 
common and preferred stock is treated as a single class of common 
stock in Years 1 and 2 for purposes of this section. Thus, S's items 
are allocated under the principles of paragraph (c)(2)(ii) of this 
section, and P decreases its basis in both the common and preferred 
stock accordingly.
    Example 2. Contribution of appreciated property. (a) Facts. P 
owns all of the stock of S and T, and S and T each own 50% of the 
stock of U. P's S stock has a $150 basis and $200 value, and P's T 
stock has a $200 basis and $200 value. With a principal purpose to 
eliminate P's gain from an anticipated sale of S's stock, T 
contributes to U an asset with a $100 value and $0 basis, and S 
contributes $100 cash. U sells T's asset and recognizes a $100 gain 
that results in a $100 positive adjustment under paragraph (b) of 
this section.
    (b) Analysis. Under paragraph (c)(2) of this section, U's 
adjustment ordinarily would be allocated equally to each share of 
U's stock. If so allocated, P's basis in S's stock would increase 
from $150 to $200 and P would recognize no gain from the sale of S's 
stock for $200. Under paragraph (e)(1) of this section, however, 
because T transferred an appreciated asset to U with a principal 
purpose to shift a portion of the stock basis increase from P's 
stock in T to P's stock in S, the allocation of the $100 positive 
adjustment under paragraph (c) of this section between the shares of 
U's stock must take into account the contribution. Consequently, all 
$100 of the positive adjustment is allocated to the U stock owned by 
T, rather than $50 to the U stock owned by S and $50 to the U stock 
owned by T. P's basis in S's stock remains $150, and its basis in 
T's stock increases to $300. Thus, P recognizes a $50 gain from its 
sale of S's stock for $200.
    Example 3. Reorganizations. (a) Facts. P forms S with an $800 
contribution, $200 of which is in exchange for S's preferred stock 
described in section 1504(a)(4) and the balance of which is for S's 
common stock. For Years 1 through 3, S has a total of $160 of 
ordinary income, $60 of which is distributed with respect to the 
preferred stock in satisfaction of its $20 annual preference as to 
dividends. Under this section, P's basis in S's preferred stock is 
unchanged, and its basis in S's common stock is increased from $600 
to $700. To reduce its gain from an anticipated sale of S's 
preferred stock, P forms T at the close of Year 3 with a 
contribution of all of S's stock in exchange for corresponding 
common and preferred stock of T in a transaction to which section 
351 applies. At the time of the contribution, the fair market value 
of the common stock is $700 and the fair market value of the 
preferred stock is $300 (due to a decrease in prevailing market 
interest rates). P subsequently sells T's preferred stock for $300.
    (b) Analysis. Under section 358(b), P ordinarily has a $630 
basis in T's common stock (70% of the $900 aggregate stock basis) 
and a $270 basis in T's preferred stock (30% of the $900 aggregate 
stock basis). However, because P transferred S's stock to T with a 
principal purpose to shift the allocation of basis adjustments under 
this section, adjustments are made under paragraph (e)(1) of this 
section to preserve the allocation under this section. Thus, P has a 
$700 basis in T's common stock and a $200 basis in T's preferred 
stock. Consequently, P recognizes a $100 gain from the sale of T's 
preferred stock.
    Example 4. Post-deconsolidation basis adjustments. (a) Facts. 
For Year 1, the P group has $40 of taxable income when determined by 
including only S's items of income, gain, deduction, and loss taken 
into account, and P increases its basis in S's stock by $40 under 
paragraph (b) of this section. P anticipates that S will have a $40 
ordinary loss for Year 2 that will be carried back and offset S's 
income in Year 1 and result in a $40 reduction to P's basis in S's 
stock for Year 2 under paragraph (b) of this section. With a 
principal purpose to avoid the reduction, P causes S to issue voting 
preferred stock that results in S becoming a nonmember at the 
beginning of Year 2. (Section 1.1502-20(b) does not reduce P's basis 
in the S stock as a result of S's deconsolidation.) As anticipated, 
S has a $40 loss for Year 2, which is carried back to Year 1 and 
offsets S's income from Year 1.
    (b) Analysis. Under paragraph (e)(1) of this section, because P 
caused S to become a nonmember with a principal purpose to absorb 
S's loss but avoid the corresponding negative adjustment under this 
section, and P bears a substantial portion of the loss because of 
its continued ownership of S common stock, the basis of P's common 
stock in S is decreased by $40 for Year 2. (If P has less than a $40 
basis in the retained S stock, P must recognize income for Year 2 to 
the extent of the excess.) Section 1504(a)(3) limits the ability of 
S to subsequently rejoin the P group's consolidated return.
    (c) Carryback to pre-consolidation year. The facts are the same 
as in paragraph (a) of this Example 4, except that P anticipates 
that S's loss will be carried back and absorbed in a separate return 
year of S before Year 1 (rather than to the P group's consolidated 
return for Year 1). Although P causes S to become a nonmember with a 
principal purpose to avoid the negative adjustment under this 
section, and P bears a substantial portion of the loss because of 
its continued ownership of S common stock, both S's income and loss 
are taken into account under the separate return rules. 
Consequently, no one has acted with a principal purpose contrary to 
the purposes of this section, and no adjustments are necessary to 
carry out the purposes of this section.
    Example 5. Pre-consolidation basis adjustments. (a) Facts. P 
forms S with a $100 contribution, and S becomes a member of the P 
affiliated group which does not file consolidated returns. For Years 
1 through 3, S earns $300. P anticipates that it will elect under 
section 1501 for the P group to begin filing consolidated returns in 
Year 5. In anticipation of filing consolidated returns, and to avoid 
the negative stock basis adjustment that would result under 
paragraph (b) of this section from distributing S's earnings after 
Year 5, P causes S to distribute $300 during Year 4 as a qualifying 
dividend within the meaning of section 243(b). There is no plan or 
intention to recontribute the funds to S after the distribution.
    (b) Analysis. Although S's distribution of $300 is with a 
principal purpose to avoid a corresponding negative adjustment under 
this section, the $300 was both earned and distributed entirely 
under the separate return rules. Consequently, P and S have not 
acted with a principal purpose contrary to the purposes of this 
section, and no adjustments are necessary to carry out the purposes 
of this section.

    (f) Predecessors and successors. For purposes of this section, any 
reference to a corporation or to a share of stock includes a reference 
to a successor or predecessor as the context may require. A corporation 
is a successor if the basis of its assets is determined, directly or 
indirectly, in whole or in part, by reference to the basis of another 
corporation (the predecessor). A share is a successor if its basis is 
determined, directly or indirectly, in whole or in part, by reference 
to the basis of another share (the predecessor).
    (g) Recordkeeping. Adjustments under this section must be reflected 
annually on permanent records (including work papers). See also section 
6001, requiring records to be maintained. The group must be able to 
identify from these permanent records the amount and allocation of 
adjustments, including the nature of any tax-exempt income and 
noncapital, nondeductible expenses, so as to permit the application of 
the rules of this section for each year.
    (h) Effective date--(1) General rule. This section applies with 
respect to determinations of the basis of the stock of a subsidiary 
(e.g., for determining gain or loss from a disposition of stock) in 
consolidated return years beginning on or after January 1, 1995. If 
this section applies, basis must be determined or redetermined as if 
this section were in effect for all years (including, for example, the 
consolidated return years of another consolidated group to the extent 
adjustments from those years are still reflected). For example, if the 
portion of a consolidated net operating loss carryover attributable to 
S expired in 1990 and is treated as a noncapital, nondeductible expense 
under paragraph (b) of this section, it is taken into account in tax 
years beginning on or after January 1, 1995 as a negative adjustment 
for 1990. Any such determination or redetermination does not, however, 
affect any prior period. Thus, the negative adjustment for S's 
noncapital, nondeductible expense is not taken into account for tax 
years beginning before January 1, 1995.
    (2) Dispositions of stock before effective date--(i) In general. If 
P disposes of stock of S in a consolidated return year beginning before 
January 1, 1995, the amount of P's income, gain, deduction, or loss, 
and the basis reflected in that amount, are not redetermined under this 
section. See Sec. 1.1502-19 as contained in the 26 CFR part 1 edition 
revised as of April 1, 1994 for the definition of disposition, and 
paragraph (h)(5) of this section for the rules applicable to such 
dispositions.
    (ii) Lower-tier members. Although P disposes of S's stock in a tax 
year beginning before January 1, 1995, S's determinations or 
adjustments with respect to the stock of a lower-tier member with which 
it continues to file a consolidated return are redetermined in 
accordance with the rules of this section (even if they were previously 
taken into account by P and reflected in income, gain, deduction, or 
loss from the disposition of S's stock). For example, assume that P 
owns all of S's stock, S owns all of T's stock, and T owns all of U's 
stock. If S sells 80% of T's stock in a tax year beginning before 
January 1, 1995 (the effective date), the amount of S's income, gain, 
deduction, or loss from the sale, and the stock basis adjustments 
reflected in that amount, are not redetermined if P sells S's stock 
after the effective date. If S sells the remaining 20% of T's stock 
after the effective date, S's stock basis adjustments with respect to 
that T stock are also not redetermined because T became a nonmember 
before the effective date. However, if T and U continue to file a 
consolidated return with each other and T sells U's stock after the 
effective date, T's stock basis adjustments with respect to U's stock 
are redetermined (even though some of those adjustments may have been 
taken into account by S in its prior sale of T's stock before the 
effective date).
    (iii) Deferred amounts. For purposes of this paragraph (h)(2), a 
disposition does not include a transaction to which Sec. 1.1502-13, 
Sec. 1.1502-13T, Sec. 1.1502-14, or Sec. 1.1502-14T applies. Instead, 
the transaction is deemed to occur as the income, gain, deduction, or 
loss (if any) is taken into account.
    (3) Distributions--(i) Deemed dividend elections. If there is a 
deemed distribution and recontribution pursuant to Sec. 1.1502-32(f)(2) 
as contained in the 26 CFR part 1 edition revised as of April 1, 1994 
in a consolidated return year beginning before January 1, 1995, the 
deemed distribution and recontribution under the election are treated 
as an actual distribution by S and recontribution by P as provided 
under the election.
    (ii) Affiliated earnings and profits. This section does not apply 
to reduce the basis in S's stock as a result of a distribution of 
earnings and profits accumulated in separate return years, if the 
distribution is made in a consolidated return year beginning before 
January 1, 1995, and the distribution does not cause a negative 
adjustment under the investment adjustment rules in effect at the time 
of the distribution. See paragraph (h)(5) of this section for the rules 
in effect with respect to the distribution.
    (4) Expiring loss carryovers. If S became a member of a 
consolidated group in a consolidated return year beginning before 
January 1, 1995, and S had a loss carryover from a separate return 
limitation year at that time, the group does not treat any expiration 
of the loss carryover (even if in a tax year beginning on or after 
January 1, 1995) as a noncapital, nondeductible expense resulting in a 
negative adjustment under this section. If S becomes a member of a 
consolidated group in a consolidated return year beginning on or after 
January 1, 1995, and S has a loss carryover from a separate return 
limitation year at that time, adjustments with respect to the 
expiration are determined under this section.
    (5) Prior law--(i) In general. For prior determinations, see prior 
regulations under section 1502 as in effect with respect to the 
determination. See, e.g., Secs. 1.1502-32 and 1.1502-32T as contained 
in the 26 CFR part 1 edition revised as of April 1, 1994.
    (ii) Continuing basis reductions for certain deconsolidated 
subsidiaries. If a subsidiary ceases to be a member of a group in a 
consolidated return year beginning before January 1, 1995, and its 
basis was subject to reduction under Sec. 1.1502-32T or Sec. 1.1502-
32(g) as contained in the 26 CFR part 1 edition revised as of April 1, 
1994, its basis remains subject to reduction under those principles. 
For example, if S ceased to be a member in 1990, and P's basis in any 
retained S stock was subject to a basis reduction account, the basis 
remains subject to reduction. Similarly, if an election could be made 
to apply Sec. 1.1502-32T instead of Sec. 1.1502-32(g), the election 
remains available. However, Secs. 1.1502-32T and 1.1502-32(g) do not 
apply as a result of a subsidiary ceasing to be a member in tax years 
beginning on or after January 1, 1995.


Sec. 1.1502-32T  [Removed]

    Par. 14. Section 1.1502-32T is removed.
    Par. 15. Section 1.1502-33 is revised to read as follows:


Sec. 1.1502-33  Earnings and profits.

    (a) In general--(1) Purpose. This section provides rules for 
adjusting the earnings and profits of a subsidiary (S) and any member 
(P) owning S's stock. These rules modify the determination of P's 
earnings and profits under applicable rules of law, including section 
312, by adjusting P's earnings and profits to reflect S's earnings and 
profits for the period that S is a member of the consolidated group. 
The purpose for modifying the determination of earnings and profits is 
to treat P and S as a single entity by reflecting the earnings and 
profits of lower-tier members in the earnings and profits of higher-
tier members and consolidating the group's earnings and profits in the 
common parent. References in this section to earnings and profits 
include deficits in earnings and profits.
    (2) Application of other rules of law. The rules of this section 
are in addition to other rules of law. For example, the allowance for 
depreciation is determined in accordance with section 312(k). P's 
earnings and profits must not be adjusted under this section and other 
rules of law in a manner that has the effect of duplicating an 
adjustment. For example, if S's earnings and profits are reflected in 
P's earnings and profits under paragraph (b) of this section, and S 
transfers its assets to P in a liquidation to which section 332 
applies, S's earnings and profits that P succeeds to under section 381 
must be adjusted to prevent duplication.
    (b) Tiering up earnings and profits--(1) General rule. P's earnings 
and profits are adjusted under this section to reflect changes in S's 
earnings and profits in accordance with the applicable principles of 
Sec. 1.1502-32, consistently applied, and an adjustment to P's earnings 
and profits for a tax year under this paragraph (b)(1) is treated as 
earnings and profits of P for the tax year in which the adjustment 
arises. Under these principles, for example, the adjustments are made 
as of the close of each consolidated return year, and as of any other 
time if a determination at that time is necessary to determine the 
earnings and profits of any person. Similarly, S's earnings and profits 
are allocated under the principles of Sec. 1.1502-32(c), and the 
adjustments are applied in the order of the tiers, from the lowest to 
the highest. However, modifications to the principles include:
    (i) The amount of P's adjustment is determined by reference to S's 
earnings and profits, rather than S's taxable and tax-exempt items (and 
therefore, for example, the deferral of a negative adjustment for S's 
unabsorbed losses does not apply).
    (ii) The tax sharing rules under paragraph (d) of this section 
apply rather than those of Sec. 1.1502-32(b)(3)(iv)(D).
    (2) Affiliated earnings and profits. The reduction in S's earnings 
and profits under section 312 from a distribution of earnings and 
profits accumulated in separate return years of S that are not separate 
return limitation years does not tier up to P's earnings and profits. 
Thus, the increase in P's earnings and profits under section 312 from 
receipt of the distribution is not offset by a corresponding reduction.
    (3) Examples--(i) In general. For purposes of the examples in this 
section, unless otherwise stated, P owns all of the only class of S's 
stock, the stock is owned for the entire year, S owns no stock of 
lower-tier members, the tax year of all persons is the calendar year, 
all persons use the accrual method of accounting, the facts set forth 
the only corporate activity, preferred stock is described in section 
1504(a)(4), all transactions are between unrelated persons, and tax 
liabilities are disregarded.
    (ii) Tiering up earnings and profits. The principles of this 
paragraph (b) are illustrated by the following examples.

    Example 1. Tier-up and distribution of earnings and profits. (a) 
Facts. P forms S in Year 1 with a $100 contribution. S has $100 of 
earnings and profits for Year 1 and no earnings and profits for Year 
2. During Year 2, S declares and distributes a $50 dividend to P.
    (b) Analysis. Under paragraph (b)(1) of this section, S's $100 
of earnings and profits for Year 1 increases P's earnings and 
profits for Year 1. P has no additional earnings and profits for 
Year 2 as a result of the $50 distribution in Year 2, because there 
is a $50 increase in P's earnings and profits as a result of the 
receipt of the dividend and a corresponding $50 decrease in S's 
earnings and profits under section 312(a) that is reflected in P's 
earnings and profits under paragraph (b)(1) of this section.
    (c) Distribution of current earnings and profits. The facts are 
the same as in paragraph (a) of this Example 1, except that S 
distributes the $50 dividend at the end of Year 1 rather than during 
Year 2. Under paragraph (b)(1) of this section, P's earnings and 
profits are increased by $100 (S's $50 of undistributed earnings and 
profits, plus P's receipt of the $50 distribution). Thus, S's 
earnings and profits increase by $50 and P's earnings and profits 
increase by $100.
    (d) Affiliated earnings and profits. The facts are the same as 
in paragraph (a) of this Example 1, except that P and S do not begin 
filing consolidated returns until Year 2. Because P and S file 
separate returns for Year 1, P's basis in S's stock remains $100 
under Sec. 1.1502-32 and this section, S has $100 of earnings and 
profits, and none of S's earnings and profits is reflected in P's 
earnings and profits under paragraph (b) of this section. S's 
distribution in Year 2 ordinarily would reduce S's earnings and 
profits but not increase P's earnings and profits. (P's $50 of 
earnings and profits from the dividend would be offset by S's $50 
reduction in earnings and profits that tiers up under paragraph (b) 
of this section.) However, under paragraph (b)(2) of this section, 
the negative adjustment for S's distribution to P does not apply. 
Thus, S's distribution reduces its earnings and profits by $50 but 
increases P's earnings and profits by $50. (If S's earnings and 
profits had been accumulated in a separate return limitation year, 
paragraph (b)(2) of this section would not apply and the 
distribution would reduce S's earnings and profits but not increase 
P's earnings and profits.)
    (e) Earnings and profits deficit. Assume instead that after P 
forms S in Year 1 with a $100 contribution, S borrows additional 
funds and has a $150 deficit in earnings and profits for Year 1. The 
corresponding loss for tax purposes is not absorbed in Year 1, and 
is included in the group's consolidated net operating loss carried 
forward to Year 2. Under paragraph (b)(1) of this section, however, 
S's $150 deficit in earnings and profits decreases P's earnings and 
profits for Year 1 by $150. (Absorption of the loss in a later tax 
year has no effect on the earnings and profits of P and S.)
    Example 2. Section 355 distribution. (a) Facts. P owns all of 
S's stock and S owns all of T's stock. For Year 1, T has $100 of 
earnings and profits. Under paragraph (b)(1) of this section, the 
earnings and profits of T tier up to S and to P. S and P have no 
other earnings and profits for Year 1. S distributes T's stock to P 
at the end of Year 1 in a distribution to which section 355 applies.
    (b) Analysis. Because S's distribution of T's stock is a 
distribution to which section 355 applies, the applicable principles 
of Sec. 1.1502-32(b)(2)(iv) do not require P's earnings and profits 
to be adjusted by reason of the distribution. In addition, although 
S's earnings and profits may be reduced under section 312(h) as a 
result of the distribution, the applicable principles of 
Sec. 1.1502-32(b)(3)(iii) do not require P's earnings and profits to 
be adjusted to reflect this reduction in S's earnings and profits.
    Example 3. Allocating earnings and profits among shares. P owns 
80% of S's stock throughout Year 1. For Year 1, S has $100 of 
earnings and profits. Under paragraph (b)(1) of this section, $80 of 
S's earnings and profits is allocated to P based on P's ownership of 
S's stock. Accordingly, $80 of S's earnings and profits for Year 1 
is reflected in P's earnings and profits for Year 1.

    (c) Special rules. For purposes of this section--
    (1) Stock of members. For purposes of determining P's earnings and 
profits from the disposition of S's stock, P's basis in S's stock is 
adjusted to reflect S's earnings and profits determined under paragraph 
(b) of this section, rather than under Sec. 1.1502-32. For example, P's 
basis in S's stock is increased by positive earnings and profits and 
decreased by deficits in earnings and profits. Similarly, P's basis in 
S's stock is not reduced for distributions to which paragraph (b)(2) of 
this section applies (affiliated earnings and profits). P may have an 
excess loss account in S's stock for earnings and profits purposes 
(whether or not there is an excess loss account under Sec. 1.1502-32), 
and the excess loss account is determined, adjusted, and taken into 
account in accordance with the principles of Secs. 1.1502-19 and 
1.1502-32.
    (2) Intercompany transactions. Earnings and profits from a 
transaction to which Sec. 1.1502-13, Sec. 1.1502-13T, Sec. 1.1502-14, 
or Sec. 1.1502-14T applies are not reflected before they are taken into 
account under the applicable principles of those sections.
    (3) Example. The principles of this paragraph (c) are illustrated 
by the following example.

    Example. Adjustments to stock basis. (a) Facts. P forms S in 
Year 1 with a $100 contribution. For Year 1, S has $75 of taxable 
income and $100 of earnings and profits. For Year 2, S has no 
taxable income or earnings and profits, and S declares and 
distributes a $50 dividend to P. P sells all of S's stock for $150 
at the end of Year 2.
    (b) Analysis. Under paragraph (c)(1) of this section, P's basis 
in S's stock for earnings and profits purposes immediately before 
the sale is $150 (the $100 initial basis, plus S's $100 of earnings 
and profits for Year 1, minus the $50 distribution of earnings and 
profits in Year 2). Thus, P recognizes no gain or loss from the sale 
of S's stock for earnings and profits purposes.
    (c) Earnings and profits deficit. Assume instead that S has a 
$100 tax loss and earnings and profits deficit for Year 1. The tax 
loss is not absorbed in Year 1 and is included in the group's 
consolidated net operating loss carried forward to Year 2. Under 
paragraph (b) of this section, S's $100 deficit in earnings and 
profits decreases P's earnings and profits for Year 1. Under 
paragraph (c) of this section, P decreases its basis in S's stock 
for purposes of determining earnings and profits from $100 to $0. 
(If S had borrowed an additional $50 that it also lost in Year 1, P 
would have decreased its earnings and profits for Year 1 by the 
additional $50, and P would have had a $50 excess loss account in 
S's stock for earnings and profits purposes, which would be taken 
into account in determining P's earnings and profits from its sale 
of S's stock.)
    (d) Affiliated earnings and profits. Assume instead that P and S 
do not begin filing consolidated returns until Year 2. Under 
paragraph (b) of this section, the negative adjustment under 
Sec. 1.1502-32(b) for distributions does not apply to S's 
distribution of earnings and profits accumulated in a separate 
return year that is a not separate return limitation year. Thus, P's 
basis in S's stock for earnings and profits purposes remains $100, 
and P has $50 of earnings and profits from the sale of S's stock.

    (d) Federal income tax liability--(1) In general--(i) Extension of 
tax allocations. Section 1552 allocates the tax liability of a 
consolidated group among its members for purposes of determining the 
amounts by which their earnings and profits are reduced for taxes. 
Section 1552 does not reflect the absorption by one member of another 
member's tax attributes (e.g., losses, deductions and credits). For 
example, if P's $100 of income is offset by S's $100 of deductions, 
consolidated tax liability is $0 and no amount is allocated under 
section 1552. However, the group may elect under this paragraph (d) to 
allocate additional amounts to reflect the absorption by one member of 
the tax attributes of another member. Permissible methods are set forth 
in paragraphs (d)(2) through (4) of this section, and election 
procedures are provided in paragraph (d)(5) of this section. 
Allocations under this paragraph (d) must be reflected annually on 
permanent records (including work papers). Any computations of separate 
return tax liability are subject to the principles of section 1561.
    (ii) Effect of extended tax allocations. The amounts allocated 
under this paragraph (d) are treated as allocations of tax liability 
for purposes of Sec. 1.1552-1(b)(2). For example, if P's taxable income 
is offset by S's loss, and tax liability is allocated under the 
percentage method of paragraph (d)(3) of this section, P's earnings and 
profits are reduced as if its income were subject to tax, P is treated 
as liable to S for the amount of the tax, and corresponding adjustments 
are made to S's earnings and profits. If the liability of one member to 
another is not paid, the amount not paid generally is treated as a 
distribution, contribution, or both, depending on the relationship 
between the members.
    (2) Wait-and-see method. The wait-and-see method under this 
paragraph (d)(2) is derived from Securities and Exchange Commission 
procedures. In the year that a member's tax attribute is absorbed, the 
group's consolidated tax liability is allocated in accordance with the 
group's method under section 1552. When, in effect, the member with the 
tax attribute could have absorbed the attribute on a separate return 
basis in a later year, a portion of the group's consolidated tax 
liability for the later year that is otherwise allocated to members 
under section 1552 is reallocated. The reallocation takes into account 
all consolidated return years to which this paragraph (d) applies (the 
computation period), and is determined by comparing the tax allocated 
to a member during the computation period with the member's tax 
liability determined as if it had filed separate returns during the 
computation period.
    (i) Cap on allocation under section 1552. A member's allocation 
under section 1552 for a tax year may not exceed the excess, if any, 
of--
    (A) The total of the tax liabilities of the member for the 
computation period (including the current year), determined as if the 
member had filed separate returns; over
    (B) The total amount allocated to the member under section 1552 and 
this paragraph (d) for the computation period (except the current 
year).
    (ii) Reallocation of capped amounts. To the extent that the amount 
allocated to a member under section 1552 exceeds the limitation under 
paragraph (d)(2)(i) of this section, the excess is allocated among the 
remaining members in proportion to (but not to exceed the amount of) 
each member's excess, if any, of--
    (A) The total of the tax liabilities of the member for the 
computation period (including the current year), determined as if the 
member had filed separate returns; over
    (B) The total amount allocated to the member under section 1552 and 
this paragraph (d) for the computation period (including for the 
current year only the amount allocated under section 1552).
    (iii) Reallocation of excess capped amounts. If the reductions 
under paragraph (d)(2)(i) of this section exceed the amounts allocable 
under paragraph (d)(2)(ii) of this section, the excess is allocated 
among the members in accordance with the group's method under section 
1552 without taking this paragraph (d)(2) into account.
    (3) Percentage method. The percentage method under this paragraph 
(d)(3) allocates tax liability based on the absorption of tax 
attributes, without taking into account the ability of any member to 
subsequently absorb its own tax attributes. The allocation under this 
method is in addition to the allocation under section 1552.
    (i) Decreased earnings and profits. A member's allocation under 
section 1552 for any year is increased, thereby decreasing its earnings 
and profits, by a fixed percentage (not to exceed 100%) of the excess, 
if any, of--
    (A) The member's separate return tax liability for the consolidated 
return year as determined under Sec. 1.1552-1(a)(2)(ii); over
    (B) The amount allocated to the member under section 1552.
    (ii) Increased earnings and profits. An amount equal to the total 
decrease in earnings and profits under paragraph (d)(3)(i) of this 
section (including amounts allocated as a result of a carryback) 
increases the earnings and profits of the members whose attributes are 
absorbed, and is allocated among them in a manner that reasonably 
reflects the absorption of the tax attributes.
    (4) Additional methods. The absorption by one member of the tax 
attributes of another member may be reflected under any other method 
approved in writing by the Commissioner.
    (5) Election of allocation method--(i) In general. Tax liability 
may be allocated under this paragraph (d) only if an election is filed 
with the group's first return. The election must--
    (A) Be made in a separate statement entitled ``ELECTION TO ALLOCATE 
TAX LIABILITY UNDER Sec. 1.1502-33(d)'';
    (B) State the allocation method elected under Sec. 1.1502-33(d) and 
under section 1552;
    (C) If the percentage method is elected, state the percentage (not 
to exceed 100%) to be used; and
    (D) If a method is permitted under paragraph (d)(4) of this 
section, attach evidence of approval of the method by the Commissioner.
    (ii) Consent--(A) Electing or changing methods. An election for a 
later year, or an election to change methods, may be made only with the 
written consent of the Commissioner.
    (B) Prior law elections. An election in effect for the last tax 
year beginning before January 1, 1995, remains in effect under this 
section. However, a group may elect to conform its earnings and profits 
computations to the method described in Sec. 1.1502-32(b)(3)(iv)(D) 
(the percentage method, using a 100% allocation), whether or not it has 
previously made an election for earnings and profits purposes. If a 
conforming election is made, the group must make all adjustments 
necessary to prevent amounts from being duplicated or omitted. The 
conforming election is made by attaching a statement entitled 
``ELECTION TO CONFORM TAX ALLOCATIONS UNDER Secs. 1.1502-32 and 1.1502-
33(d)'' to the consolidated group's return for its first tax year 
beginning on or after January 1, 1995. The statement must be signed by 
the common parent, and must specify whether the method is conformed 
only for years beginning on or after January 1, 1995 or as if the 
method were in effect for all prior years. The statement must also 
describe the adjustments made by reason of the change (e.g., to reflect 
prior use of earnings and profits).
    (6) Examples. The principles of this paragraph (d) are illustrated 
by the following examples.

    Example 1. Wait-and-see method. (a) Facts. P owns all of the 
stock of S1 and S2. The P group uses the wait-and-see method of 
allocation under paragraph (d)(2) of this section in conjunction 
with Sec. 1.1552-1(a)(1). For Year 1, each member's taxable income, 
both for purposes of Sec. 1.1552-1(a)(1) and redetermined as if the 
member had filed separate returns, is as follows: P $0, S1 $2,000, 
and S2 ($1,000). Thus, the P group's consolidated tax liability for 
Year 1 is $340 (assuming a 34% tax rate).
    (b) Analysis. Under Sec. 1.1552-1(a)(1)(i), the tax liability of 
the P group is allocated among the members in accordance with the 
portion of the consolidated taxable income attributable to each 
member having taxable income. Thus, all of the P group's $340 
consolidated tax liability is allocated to S1. As a result, S1 
decreases its earnings and profits under section 1552 by $340 (even 
if S1 does not pay the tax liability). No further allocations are 
made under paragraph (d)(2) of this section because S2 cannot yet 
absorb its loss on a separate return basis.
    (c) Payment of tax liability. If S1 pays the $340 tax liability, 
there is no further effect on the income, earnings and profits, or 
stock basis of any member. If P pays the $340 tax liability (and the 
payment is not a loan from P to S1), P is treated as making a $340 
contribution to the capital of S1; if S2 pays the $340 tax liability 
(and the payment is not a loan from S2 to S1), S2 is treated as 
making a $340 distribution to P with respect to its stock, and P is 
treated as making a $340 contribution to the capital of S1. See 
Sec. 1.1552-1(b)(2).
    (d) Year 2. For Year 2, each member's taxable income, under 
Sec. 1.1552-1(a)(1)(ii) and redetermined as if the member had filed 
separate returns, without taking into account any carryover from 
Year 1, is as follows: P $0, S1 $1,000, and S2 $3,000. Thus, the P 
group's consolidated tax liability for Year 2 is $1,360 (assuming a 
34% tax rate). Of this amount, section 1552 would allocate $340 to 
S1 and $1,020 to S2. However, under paragraph (d)(2)(i) of this 
section, no more than $680 may be allocated to S2. This is because 
S2 would have had an aggregate tax liability of $680 if it had filed 
separate returns for Years 1 and 2 (a $0 tax liability for Year 1, 
and a $680 tax liability for Year 2, taking into account a $1,000 
net operating loss carryover from Year 1). Under paragraph 
(d)(2)(ii) of this section, the entire excess of $340 which would 
otherwise be allocated to S2 under Sec. 1.1552-1(a)(1) is allocated 
to S1. This is because S1 would have had an additional $340 of 
aggregate tax liability if it had filed separate returns for Years 1 
and 2 (a $680 tax liability for Year 1, and a $340 tax liability for 
Year 2, not taking into account S2's $1,000 net operating loss for 
Year 1). The effect of the allocation of $680 to S1 and $680 to S2 
is determined under Sec. 1.1552-1(b)(2).
    Example 2. Percentage method. (a) Facts. The facts are the same 
as in Example 1, but the P group uses the percentage method of 
allocation under paragraph (d)(3) of this section, with a percentage 
of 100%. In addition, the taxable incomes and losses of the members 
are the same if computed as provided in Sec. 1.1552-1(a)(2)(ii).
    (b) Analysis. Under Sec. 1.1552-1(a)(2)(ii), $340 of tax 
liability is allocated to S1 for Year 1. Under paragraph (d)(3)(i) 
of this section, S1 is allocated another $340 of tax liability 
because S1 would have had a $680 tax liability if it had filed 
separate returns but only $340 is allocated to S1 under section 
1552. Thus, S1's earnings and profits are decreased by the $680 
total. Under paragraph (d)(3)(ii) of this section, S2's earnings and 
profits are increased by $340 because the additional $340 allocated 
to S1 under paragraph (d)(3)(i) of this section is attributable to 
the absorption of S2's losses.
    (c) Payment of tax liability. If S1 pays the $340 tax liability 
of the P group and pays $340 to S2, the Year 1 tax liability results 
in no further adjustments to the income, earnings and profits, or 
basis of any member's stock. If S1 pays the $340 tax liability of 
the P group and pays the other $340 to P instead of S2 because, for 
example, of an agreement among the members, S2 is treated as 
distributing $340 to P with respect to its stock in the year that S1 
makes the payment to P. See Sec. 1.1552-1(b)(2).
    (d) Year 2. For Year 2, $340 is allocated to S1 and $1,020 is 
allocated to S2 under section 1552. No additional amounts are 
allocated under paragraph (d)(3) of this section.

    (e) Deconsolidations--(1) In general. Immediately before it becomes 
a nonmember, S's earnings and profits are eliminated to the extent they 
were taken into account by any member under this section. If S's 
earnings and profits are eliminated under this paragraph (e)(1), no 
corresponding adjustment is made to the earnings and profits of P (or 
any other member) under paragraph (b) of this section or to any basis 
in a member's stock under paragraph (c) of this section. For this 
purpose, S is treated as becoming a nonmember on the first day of its 
first separate return year (including another group's consolidated 
return year).
    (2) Acquisition of group--(i) Application. This paragraph (e)(2) 
applies only if a consolidated group (the terminating group) ceases to 
exist as a result of--
    (A) The acquisition by a member of another consolidated group of 
either the assets of the common parent of the terminating group in a 
reorganization described in section 381(a)(2), or the stock of the 
common parent of the terminating group; or
    (B) The application of the principles of Sec. 1.1502-75(d)(2) or 
(d)(3).
    (ii) General rule. Paragraph (e)(1) of this section does not apply 
solely by reason of the termination of a group because it is acquired, 
if there is a surviving group that is, immediately thereafter, a 
consolidated group. Instead, the surviving group is treated as the 
terminating group for purposes of applying this paragraph (e) to the 
terminating group. This treatment does not apply, however, to members 
of the terminating group that are not members of the surviving 
consolidated group immediately after the terminating group ceases to 
exist (e.g., under section 1504(a)(3) relating to reconsolidation, or 
section 1504(c) relating to includible insurance companies).
    (3) Certain corporate separations and reorganizations. The 
adjustments under paragraph (e)(1) of this section must be modified to 
the extent necessary to effectuate the principles of section 312(h). 
Thus, P's earnings and profits rather than S's earnings and profits may 
be eliminated immediately before S becomes a nonmember. P's earnings 
and profits are eliminated to the extent that its earnings and profits 
reflect S's earnings and profits after applying section 312(h) 
immediately after S becomes a nonmember (determined without taking this 
paragraph (e) into account).
    (4) Special uses of earnings and profits. Paragraph (e)(1) of this 
section does not apply for purposes of determining--
    (i) The extent to which a distribution is charged to reserve 
accounts under section 593(e);
    (ii) The extent to which a distribution is taxable to the recipient 
under sections 805(a)(4) and 832; and
    (iii) Any other special use identified in guidance published in the 
Internal Revenue Bulletin.
    (5) Example. The principles of this paragraph (e) are illustrated 
by the following example.

    Example. (a) Facts. Individuals A and B own all of P's stock, 
and P owns all of the stock of S and T, each with a $500 basis. For 
Year 1, S has $100 of earnings and profits and T has $50 of earnings 
and profits. Under paragraph (b)(1) of this section, the earnings 
and profits of S and T tier up to P, and P has $150 of earnings and 
profits for Year 1. P sells all of S's stock for $600 at the close 
of Year 1.
    (b) Analysis. Under paragraph (e)(1) of this section, S's $100 
of earnings and profits is eliminated immediately before S becomes a 
nonmember because the earnings and profits are taken into account 
under paragraph (b) of this section in P's earnings and profits. 
However, no corresponding adjustment is made to P's earnings and 
profits or to P's basis in S's stock for purposes of earnings and 
profits. P's earnings and profits for Year 1 remain $150 following 
the sale of S's stock.
    (c) Forward merger. The facts are the same as in paragraph (a) 
of this Example, except that, rather than P selling S's stock, S 
merges into a nonmember in a transaction described in section 
368(a)(2)(D). Under paragraph (h) of this section, the nonmember is 
treated as a successor to S. Thus, as in paragraph (b) of this 
Example, S's $100 of earnings and profits is eliminated immediately 
before S ceases to be a member.
    (d) Acquisition of entire group. The facts are the same as in 
paragraph (a) of this Example, except that X, the common parent of 
another consolidated group, purchases all of P's stock at the close 
of Year 1, and P sells S's stock during Year 3. Under paragraph 
(e)(2) of this section, the earnings and profits of S and T are not 
eliminated as a result of X purchasing P's stock. However, S's 
earnings and profits from consolidated return years of both the P 
group and the X group are eliminated immediately before S becomes a 
nonmember of the X group.
    (e) Earnings and profits deficit. The facts are the same as in 
paragraph (d) of this Example, except that S has a $550 deficit in 
earnings and profits for Year 1. The effect of paragraph (e)(1) of 
this section is the same. Under paragraph (c)(1) of this section, P 
would have an excess loss account in S's stock for earnings and 
profits purposes under the principles of Secs. 1.1502-19 and 1.1502-
32, and, under the principles of Sec. 1.1502-19(c)(2), the excess 
loss account is not taken into account as a result of X's purchase 
of P's stock. Under paragraph (e)(2) of this section, S's deficit is 
not eliminated under paragraph (e)(1) of this section immediately 
before X's purchase of P's stock. However, S's earnings and profits 
(or deficit) is eliminated immediately before S becomes a nonmember 
of the X group.
    (f) Section 355 distribution. The facts are the same as in 
paragraph (a) of this Example, except that, rather than selling S's 
stock, P distributes S's stock to A at the close of Year 1 in a 
distribution to which section 355 applies. Under paragraph (e)(3) of 
this section, P's earnings and profits may be reduced under section 
312(h) as a result of the distribution. To the extent that P's 
earnings and profits are reduced, S's earnings and profits are not 
eliminated under paragraph (e)(1) of this section.

    (f) Changes in the structure of the group--(1) Changes in the 
common parent--(i) General rule. If P succeeds another corporation 
under the principles of Sec. 1.1502-75(d) (2) or (3) as the common 
parent of a consolidated group (a group structure change), the earnings 
and profits of P are adjusted immediately after P becomes the new 
common parent to reflect the earnings and profits of the former common 
parent immediately before the former common parent ceases to be the 
common parent. The adjustment is made as if P succeeds to the earnings 
and profits of the former common parent in a transaction described in 
section 381(a). See Sec. 1.1502-31 for the basis of the stock of 
members following a group structure change.
    (ii) Minority shareholders. If the former common parent's stock is 
not wholly owned by members of the consolidated group immediately after 
the former common parent ceases to be the common parent, appropriate 
adjustments must be made to reflect in the new common parent only an 
allocable part of the former common parent's earnings and profits.
    (iii) Higher-tier members. To the extent that earnings and profits 
are adjusted under this paragraph (f)(1), and the former common parent 
is owned by members other than P, the earnings and profits of the 
intermediate subsidiaries must be adjusted in accordance with the 
principles of this section.
    (iv) Example. The principles of this paragraph (f)(1) are 
illustrated by the following example.

    Example. (a) Facts. X is the common parent of a consolidated 
group with $100 of earnings and profits, and P is the common parent 
of another consolidated group with $20 of earnings and profits. P 
acquires all of X's stock at the close of Year 1 in exchange for 70% 
of P's stock. The exchange is a reverse acquisition under 
Sec. 1.1502-75(d)(3), and the X group is treated as remaining in 
existence with P as its new common parent.
    (b) Adjustments for X group earnings and profits. Under 
paragraph (f)(1) of this section, P's earnings and profits are 
adjusted immediately after P becomes the new common parent, to 
reflect X's $100 of earnings and profits immediately before X ceases 
to be the common parent. The adjustment is made as if P succeeds to 
X's earnings and profits in a transaction described in section 
381(a). Thus, immediately after the acquisition, P has $120 of 
accumulated earnings and profits and X continues to have $100 of 
accumulated earnings and profits.
    (c) Adjustments for P group earnings and profits. Although the P 
group terminates on P's acquisition of X's stock, under paragraph 
(e)(2) of this section, no adjustments are made to the earnings and 
profits of any subsidiaries in the terminating P group.
    (d) Acquisition of separate return corporation. The facts are 
the same as in paragraph (a) of this Example, except that, 
immediately before the acquisition of its stock by P, X is not 
affiliated with any other corporation. The exchange is a reverse 
acquisition under Sec. 1.1502-75(d)(3), and P is treated as the 
common parent of the X group. Consequently, the results are the same 
as in paragraphs (b) and (c) of this Example.

    (2) Change in the location of subsidiaries. If the location of a 
member within a group changes, appropriate adjustments must be made to 
the earnings and profits of the members to prevent the earnings and 
profits from being eliminated. For example, if P transfers all of S's 
stock to another member in a transaction to which section 351 and 
Sec. 1.1502-13 apply, the transferee's earnings and profits are 
adjusted immediately after the transfer to reflect S's earnings and 
profits immediately before the transfer from consolidated return years. 
On the other hand, if the transferee purchases S's stock from P, the 
transferee's earnings and profits are not adjusted.
    (g) Anti-avoidance rule. If any person acts with a principal 
purpose contrary to the purposes of this section, to avoid the effect 
of the rules of this section or apply the rules of this section to 
avoid the effect of any other provision of the consolidated return 
regulations, adjustments must be made as necessary to carry out the 
purposes of this section.
    (h) Predecessors and successors. For purposes of this section, any 
reference to a corporation or to a share includes a reference to a 
successor or predecessor as the context may require. A corporation is a 
successor if its earnings and profits are determined, directly or 
indirectly, in whole or in part, by reference to the earnings and 
profits of another corporation (the predecessor). A share is a 
successor if its basis is determined, directly or indirectly, in whole 
or in part, by reference to the basis of another share (the 
predecessor).
    (i) [Reserved]
    (j) Effective date--(1) General rule. This section applies with 
respect to determinations of the earnings and profits of a member 
(e.g., for purposes of a characterizing a distribution to which section 
301 applies) in consolidated return years beginning on or after January 
1, 1995. If this section applies, earnings and profits must be 
determined or redetermined as if this section were in effect for all 
years (including, for example, the consolidated return years of another 
consolidated group to the extent the earnings and profits from those 
years are still reflected). For example, if a distribution by P to a 
nonmember shareholder in 1990 was a dividend because of an unabsorbed 
loss carryover attributable to S, P's earnings and profits in tax years 
beginning after January 1, 1995 are redetermined by taking into account 
a negative adjustment in the tax year S's loss arose and in 1990 for 
P's distribution, and any subsequent absorption of the loss has no 
effect on earnings and profits. Any such determination or 
redetermination does not, however, affect any prior period. Thus, the 
shareholder's treatment in 1990 of the distribution as a dividend (and 
the effect of the distribution on stock basis) is not redetermined 
under this section.
    (2) Dispositions of stock before effective date--(i) In general. If 
P disposes of stock of S in a consolidated return year beginning before 
January 1, 1995, the amount of P's earnings and profits with respect to 
S are not redetermined under paragraph (j)(1) of this section. See 
Sec. 1.1502-19 as contained in the 26 CFR part 1 edition revised as of 
April 1, 1994 for the definition of disposition, and paragraph (j)(5) 
of this section for the rules applicable to such dispositions.
    (ii) Lower-tier members. Although P disposes of S's stock in a tax 
year beginning before January 1, 1995, S's determinations or 
adjustments with respect to lower-tier members with which it continues 
to file a consolidated return are redetermined in accordance with the 
rules of this section (even if S's earnings and profits were previously 
taken into account by P). For example, assume that P owns all of S's 
stock, S owns all of T's stock, and T owns all of U's stock. If S sells 
80% of T's stock in a tax year beginning before January 1, 1995 (the 
effective date), the amount of S's earnings and profits from the sale, 
and the adjustments to stock basis for earnings and profits purposes 
that are reflected in that amount, are not redetermined if P sells S's 
stock after the effective date. If S sells the remaining 20% of T's 
stock after the effective date, S's stock basis adjustments with 
respect to that T stock are also not redetermined because T became a 
nonmember before the effective date. However, if T and U continue to 
file a consolidated return with each other, paragraph (e)(1) of this 
section did not apply, and T sells U's stock after the effective date, 
T's earnings and profits with respect to U are redetermined (even 
though some of the earnings and profits may have been taken into 
account by S in its prior sale of T's stock before the effective date).
    (iii) Deferred amounts. For purposes of this paragraph (j)(2), a 
disposition does not include a transaction to which Sec. 1.1502-13, 
Sec. 1.1502-13T, Sec. 1.1502-14, or Sec. 1.1502-14T applies. Instead, 
the transaction is deemed to occur as the earnings and profits (if any) 
are taken into account.
    (3) Deconsolidations and group structure changes--(i) In general. 
Paragraphs (e) and (f) of this section apply with respect to 
deconsolidations and group structure changes occurring in consolidated 
return years beginning on or after January 1, 1995.
    (ii) Prior period group structure changes. If there was a group 
structure change in a consolidated return year beginning before January 
1, 1995, and earnings and profits were not determined under 
Sec. 1.1502-33T(a) as contained in the 26 CFR part 1 edition revised as 
of April 1, 1994, a distribution in a tax year ending after September 
7, 1988, of earnings and profits that are not reflected in the earnings 
and profits of the distributee member, but would have been so reflected 
if Sec. 1.1502-33T(a) as contained in the 26 CFR part 1 edition revised 
as of April 1, 1994 had applied, the negative adjustment under 
paragraph (b) of this section for distributions does not apply (and 
there is therefore no offset to the increase in the earnings and 
profits of the distributee).
    (4) Deemed dividend elections. If there is a deemed distribution 
and recontribution pursuant to Sec. 1.1502-32(f)(2) as contained in the 
26 CFR part 1 edition revised as of April 1, 1994 in a consolidated 
return year beginning before January 1, 1995, the deemed distribution 
and recontribution under the election are treated as an actual 
distribution by S and recontribution by P as provided under the 
election.
    (5) Prior law. For prior determinations, see prior regulations 
under section 1502 as in effect with respect to the determination. See, 
e.g., Secs. 1.1502-33 and 1.1502-33T as contained in the 26 CFR part 1 
edition revised as of April 1, 1994.


Sec. 1.1502-33T  [Removed]

    Par. 16. Section 1.1502-33T is removed.
    Par. 17. Section 1.1502-75 is amended by revising the first 
sentence of paragraph (d)(1) to read as follows:


Sec. 1.1502-75  Filing of consolidated returns.

* * * * *
    (d) * * *
    (1) * * * A group remains in existence for a tax year if the common 
parent remains as the common parent and at least one subsidiary that 
was affiliated with it at the end of the prior year remains affiliated 
with it at the beginning of the year, whether or not one or more 
corporations have ceased to be subsidiaries at any time after the group 
was formed. * * *
* * * * *
    Par. 18. Section 1.1502-76 is amended by:
    1. Revising paragraph (b).
    2. Removing paragraph (d).
    3. The revision reads as follows:


Sec. 1.1502-76  Taxable year of members of group.

* * * * *
    (b) Items included in the consolidated return--(1) General rules--
(i) In general. A consolidated return must include the common parent's 
items of income, gain, deduction, loss, and credit for the entire 
consolidated return year, and each subsidiary's items for the portion 
of the year for which it is a member. If the consolidated return 
includes the items of a corporation for only a portion of its tax year 
determined without taking this section into account, items for the 
portion of the year not included in the consolidated return must be 
included in a separate return (including the consolidated return of 
another group). The rules of this paragraph (b) must be applied to 
prevent the duplication or elimination of the corporation's items.
    (ii) The day a corporation becomes or ceases to be a member--(A) 
End of the day rule. If a corporation (S) becomes or ceases to be a 
member during a consolidated return year, it becomes or ceases to be a 
member at the end of the day on which its status as a member changes, 
and its tax year ends for all Federal income tax purposes at the end of 
that day. Appropriate adjustments must be made if another provision of 
the Internal Revenue Code or the regulations thereunder contemplates 
the event occurring before or after S's change in status. For example, 
S's items restored under Sec. 1.1502-13 immediately before it becomes a 
nonmember are taken into account in determining the basis of S's stock 
under Sec. 1.1502-32. On the other hand, if a section 338(g) election 
is made in connection with S becoming a member, the deemed asset sale 
under that section takes place before S becomes a member. See 
Sec. 1.338-1(e)(5) (deemed sale excluded from purchasing corporation's 
consolidated return.)
    (B) Next day rule. If, on the day of S's change in status as a 
member, a transaction occurs that is properly allocable to the portion 
of S's day after the event resulting in the change, S and all persons 
related to S under section 267(b) immediately after the event must 
treat the transaction for all Federal income tax purposes as occurring 
at the beginning of the following day. A determination as to whether a 
transaction is properly allocable to the portion of S's day after the 
event will be respected if it is reasonable and consistently applied by 
all affected persons. In determining whether an allocation is 
reasonable, the following factors are among those to be considered--
    (1) Whether income, gain, deduction, loss, and credit are allocated 
inconsistently (e.g., to maximize a seller's stock basis adjustments 
under Sec. 1.1502-32);
    (2) If the item is from a transaction with respect to S stock, 
whether it reflects ownership of the stock before or after the event 
(e.g., if a member transfers encumbered land to nonmember S in exchange 
for additional S stock in a transaction to which section 351 applies 
and the exchange results in S becoming a member of the consolidated 
group, the applicability of section 357(c) to the exchange must be 
determined under Sec. 1.1502-80(d) by treating the exchange as 
occurring after the event; on the other hand, if S is a member but has 
a minority shareholder and becomes a nonmember as a result of its 
redemption of stock with appreciated property, S's gain under section 
311 is treated as from a transaction occurring before the event);
    (3) Whether the allocation is inconsistent with other requirements 
under the Internal Revenue Code (e.g., if a section 338(g) election is 
made in connection with a group's acquisition of S, the deemed asset 
sale must take place before S becomes a member and S's gain or loss 
with respect to its assets must be taken into account by S as a 
nonmember); and
    (4) Whether other facts exist, such as a prearranged transaction or 
multiple changes in S's status, indicating that the transaction is not 
properly allocable to the portion of S's day after the event resulting 
in S's change.
    (C) Successor corporations. For purposes of this paragraph 
(b)(1)(ii), any reference to a corporation includes a reference to a 
successor or predecessor as the context may require. A corporation is a 
successor if the basis of its assets is determined, directly or 
indirectly, in whole or in part, by reference to the basis of the 
assets of another corporation (the predecessor). For example, if a 
member forms S, S is treated as a member from the beginning of its 
existence.
    (iii) Group structure changes. If the common parent ceases to be 
the common parent but the group remains in existence, adjustments must 
be made in accordance with the principles of Sec. 1.1502-75(d)(2) and 
(3).
    (2) Determination of items included in separate and consolidated 
returns--(i) In general. The returns for the years that end and begin 
with S becoming (or ceasing to be) a member are separate tax years for 
all Federal income tax purposes. The returns are subject to the rules 
of the Internal Revenue Code applicable to short periods, as if S 
ceased to exist on becoming a member (or first existed on becoming a 
nonmember). For example, cost recovery deductions under section 168 
must be allocated for short periods. On the other hand, annualization 
under section 443 is not required of S solely because it has a short 
year as a result of becoming a member. (Similarly, section 443 applies 
with respect to a consolidated return only to the extent that the 
group's return is for a short period and section 443 applies without 
taking this paragraph (b) into account.)
    (ii) Ratable allocation of a year's items--(A) Application. 
Although the periods ending and beginning with S's change in status are 
different tax years, items (other than extraordinary items) may be 
ratably allocated between the periods if--
    (1) S is not required to change its annual accounting period or its 
method of accounting as a result of its change in status (e.g., because 
its stock is sold between consolidated groups that have the same annual 
accounting periods); and
    (2) An irrevocable ratable allocation election is made under 
paragraph (b)(2)(ii)(D) of this section.
    (B) General rule--(1) Allocation within original year. Under a 
ratable allocation election, paragraph (b)(2) of this section applies 
by allocating to each day of S's original year (S's tax year determined 
without taking this section into account) an equal portion of S's items 
taken into account in the original year, except that extraordinary 
items must be allocated to the day that they are taken into account. 
All persons affected by the election must take into account S's 
extraordinary items and the ratable allocation of S's remaining items 
in a manner consistent with the election.
    (2) Items to be allocated. Under ratable allocation, the items to 
be allocated and their timing, location, character, and source are 
generally determined by treating the original year as a single tax 
year, and the items are not subject to the rules of the Internal 
Revenue Code applicable to short periods (unless the original year is a 
short period). However, the years ending and beginning with S's change 
in status are treated as different tax years (and as short periods) 
with respect to any item carried to or from these years (e.g., a net 
operating loss carried under section 172) and with respect to the 
application of section 481.
    (3) Multiple applications. If this paragraph (b) applies more than 
once with respect to an original year, adjustments must be made in 
accordance with the principles of this paragraph (b). For example, if S 
becomes a member of two different consolidated groups during the same 
original year and ratable allocation is elected with respect to both 
groups, ratable allocation is generally determined for both groups by 
treating the original year as a single tax year; however, if ratable 
allocation is elected only with respect to the first group, the ratable 
allocation is determined by treating the original year as a short 
period that does not include the period that S is a member of the 
second group. Ratable allocation is not a method of accounting, and 
ratable allocation with respect to one application of this paragraph 
(b) to S does not require ratable allocation to be subsequently applied 
with respect to S.
    (C) Extraordinary items. An extraordinary item is--
    (1) Any item from the disposition or abandonment of a capital asset 
as defined in section 1221 (determined without the application of any 
other rules of law);
    (2) Any item from the disposition or abandonment of property used 
in a trade or business as defined in section 1231(b) (determined 
without the application of any holding period requirement);
    (3) Any item from the disposition or abandonment of an asset 
described in section 1221(1), (3), (4), or (5), if substantially all 
the assets in the same category from the same trade or business are 
disposed of or abandoned in one transaction (or series of related 
transactions);
    (4) Any item from assets disposed of in an applicable asset 
acquisition under section 1060(c);
    (5) Any item carried to or from any portion of the original year 
(e.g., a net operating loss carried under section 172), and any section 
481(a) adjustment;
    (6) The effects of any change in accounting method initiated by the 
filing of the appropriate form after S's change in status;
    (7) Any item from the discharge or retirement of indebtedness 
(e.g., cancellation of indebtedness income or a deduction for 
retirement at a premium);
    (8) Any item from the settlement of a tort or similar third-party 
liability;
    (9) Any compensation-related deduction in connection with S's 
change in status (including, for example, deductions from bonus, 
severance, and option cancellation payments made in connection with S's 
change in status);
    (10) Any dividend income from a nonmember that S controls within 
the meaning of section 304 at the time the dividend is taken into 
account;
    (11) Any deemed income inclusion from a foreign corporation, or any 
deferred tax amount on an excess distribution from a passive foreign 
investment company under section 1291;
    (12) Any interest expense allocable under section 172(h) to a 
corporate equity reduction transaction causing this paragraph (b) to 
apply;
    (13) Any credit, to the extent it arises from activities or items 
that are not ratably allocated (e.g., the rehabilitation credit under 
section 47, which is based on placement in service); and
    (14) Any item which, in the opinion of the Commissioner, would, if 
ratably allocated, result in a substantial distortion of income in any 
consolidated return or separate return in which the item is included.
    (D) Election. The election to ratably allocate items under this 
paragraph (b)(2)(ii) must be made in a separate statement entitled 
``THIS IS AN ELECTION UNDER Sec. 1.1502-76(b)(2)(ii) TO RATABLY 
ALLOCATE THE YEAR'S ITEMS OF [insert name and employer identification 
number of the member].'' The statement must be signed by the member and 
by the common parent of each affected group, and must be filed with the 
returns including the items for the year's ending and beginning with 
S's change in status. If two or more members of the same consolidated 
group, as a consequence of the same plan or arrangement, cease to be 
members of that group and remain affiliated as members of another 
consolidated group, an election under this paragraph (b)(2)(ii)(D) may 
be made only if it is made by each such member. The statement must 
provide all of the following:
    (1) Identify the extraordinary items, their amounts, and the 
separate or consolidated returns in which they are included.
    (2) Identify the aggregate amount to be ratably allocated, and the 
portion of the amount included in the separate and consolidated 
returns.
    (3) Include the name and employer identification number of the 
common parent (if any) of each group that must take the items into 
account.
    (iii) Ratable allocation of a month's items. If ratable allocation 
under paragraph (b)(2)(ii) of this section is not elected (e.g., 
because S is required to change its annual accounting period), this 
paragraph (b)(2)(iii) may be applied to ratably allocate only S's items 
taken into account in the month of its change in status, but only if 
the allocation is consistently applied by all affected persons. The 
ratable allocation is made by applying the principles of paragraph 
(b)(2)(ii) of this section under any reasonable method. For example, S 
may close its books both at the end of the preceding month and at the 
end of the month of the change, and allocate only its items (other than 
extraordinary items) from the month of the change. See paragraph 
(b)(1)(ii)(B) of this section for factors to be considered in 
determining whether the method is reasonable.
    (iv) Taxes. To the extent properly taken into account during the 
member's tax year (determined without the application of this paragraph 
(b)), Federal, state, local, and foreign taxes are allocated under 
paragraph (b)(2) of this section on the basis of the items or 
activities to which the taxes relate. Thus, income tax is allocated 
based on the inclusion of the income (determined under the principles 
of this paragraph (b)) to which the tax relates. For example, if a 
calendar-year domestic corporation has $100 of foreign source dividend 
income (determined in accordance with United States tax accounting 
principles but without taking this paragraph (b) into account) that is 
passive income for purposes of section 904, and $60 of the income is 
allocated under this paragraph (b) to the period of the calendar year 
after it becomes a member of a consolidated group, then 60% of the 
corporation's deemed paid foreign tax credit associated with its 
dividend income for the calendar year is taken into account in 
computing the group's passive basket consolidated foreign tax credit. 
Similarly, property taxes relate to the ownership of property and are 
allocated over the period that the property is owned. This paragraph 
(b)(2)(iv) applies without regard to any determination or allocation by 
another taxing jurisdiction.
    (v) Passthrough entities--(A) In general. If S is a partner in a 
partnership or an owner of a similar interest with respect to which 
items of the entity are taken into account by S, S is treated, solely 
for purposes of determining the year to which the entity's items are 
allocated under paragraph (b)(2) of this section, as selling or 
exchanging its entire interest in the entity immediately before S's 
change in status.
    (B) Treatment as a conduit. For purposes of this paragraph (b)(2), 
if a member (together with other members) would be treated under 
section 318(a)(2) as owning an aggregate of at least 50% of any stock 
owned by the passthrough entity, the method that is used to determine 
the inclusion of the entity's items in the consolidated or separate 
return must be the same method that is used to determine the inclusion 
of the member's items in the consolidated or separate return.
    (C) Exception for certain foreign entities. This paragraph 
(b)(2)(v) does not apply to any foreign corporation generating the 
deemed inclusion of income, or to any passive foreign investment 
company generating a deferred tax amount on an excess distribution 
under section 1291.
    (3) Anti-avoidance rule. If any person acts with a principal 
purpose contrary to the purposes of this paragraph (b), to 
substantially reduce the Federal income tax liability of any person, 
adjustments must be made as necessary to carry out the purposes of this 
section.
    (4) Examples. For purposes of the examples in this paragraph (b), 
unless otherwise stated, P and X are common parents of calendar-year 
consolidated groups, P owns all of the only class of T's stock, T owns 
no stock of lower-tier members, all persons use the accrual method of 
accounting, the facts set forth the only corporate activity, all 
transactions are between unrelated persons, tax liabilities are 
disregarded, and any election required under paragraph (b)(2) of this 
section is properly made. The principles of this paragraph (b) are 
illustrated by the following examples.

    Example 1. Items allocated between consolidated and separate 
returns. (a) Facts. P and S are the only members of the P group. P 
sells all of S's stock to individual A, and S becomes a nonmember on 
July 1 of Year 2.
    (b) Analysis. Under paragraph (b)(1) of this section, the P 
group's consolidated return for Year 2 includes P's income for the 
entire tax year and S's income for the period from January 1 to June 
30, and S must file a separate return for the period from July 1 to 
December 31.
    (c) Acquisition of another subsidiary before end of tax year. 
The facts are the same as in paragraph (a) of this Example 1, except 
that P acquires all the stock of T (which filed a separate return 
for its year ending on November 30 of Year 1) and T becomes a member 
on August 1 of Year 2. Under Sec. 1.1502-75(d) and paragraph (b)(1) 
of this section, the P group's consolidated return for Year 2 
includes P's income for the entire year, S's income from January 1 
to June 30, and T's income from August 1 to December 31. S must file 
a separate return that includes its income from July 1 to December 
31, and T must file a separate return that includes its income from 
December 1 of Year 1 to July 31 of Year 2. (If P had acquired T 
after December 31, the P group that included S is a different group 
from the P group that includes T, and, for example, the P group that 
includes T must make a separate election under section 1501 and 
Sec. 1.1502-75 if consolidated returns are to be filed.)
    Example 2. Group structure change. (a) Facts. P owns all of the 
stock of S and T. Shortly after the beginning of Year 1, P merges 
into T in a reorganization described in section 368(a)(1)(A) (and in 
section 368(a)(1)(D)), and P's shareholders receive T's stock in 
exchange for all of P's stock. The P group is treated under 
Sec. 1.1502-75(d)(2)(ii) as remaining in existence with T as its 
common parent.
    (b) Analysis. Under paragraph (b)(1) of this section, the P 
group's return must include the common parent's items for the entire 
consolidated return year and, if the common parent ceases to be the 
common parent but the group remains in existence, appropriate 
adjustments must be made. Consequently, although P did not exist for 
all of Year 1, P's items for the portion of Year 1 ending with the 
merger are treated as the items of the common parent that must be 
included in the P group's return for Year 1.
    (c) Reverse acquisition. Assume instead that X acquires all of 
P's assets in exchange for more than 50% of X's stock in a 
reorganization described in section 368(a)(1)(D). The reorganization 
constitutes a reverse acquisition under Sec. 1.1502-75(d)(3), with 
the X group terminating and the P group surviving with X as its 
common parent. Consequently, P's items for the portion of Year 1 
ending with the acquisition are treated as the items of the common 
parent that must be included in the P group's return for Year 1, and 
X's items are treated for purposes of paragraph (b)(1) of this 
section as the items of a subsidiary included in the P group's 
return for the portion of Year 1 for which X is a member.
    Example 3. Ratable allocation. (a) Facts. P sells all of T's 
stock to X, and T becomes a nonmember on July 1 of Year 1. T engages 
in the production and sale of merchandise throughout Year 1 and is 
required to use inventories. The sale is treated as causing T's tax 
year to end on June 30, and the periods beginning and ending with 
the sale are treated as two tax years for Federal income tax 
purposes.
    (b) Analysis. If ratable allocation under paragraph (b)(2)(ii) 
of this section is not elected, T must perform an inventory 
valuation as of the acquisition and also as of the end of Year 1. If 
ratable allocation is elected, T must perform an inventory valuation 
only as of the close of Year 1, and T's income from inventory is 
ratably allocated, along with T's other items that are not 
extraordinary items, between the P and X consolidated returns.
    (c) Merger into nonmember. Assume instead that T merges into a 
wholly owned subsidiary of X in a reorganization described in 
section 368(a)(2)(D), and P receives 10% of X's stock in exchange 
for all of T's stock. Under paragraph (b)(2)(ii)(B) of this section, 
because T's tax year ends on June 30 under section 381(b)(1), T's 
original year determined without taking paragraph (b) of this 
section into account also ends on June 30. Consequently, a ratable 
allocation under paragraph (b)(2)(ii) of this section is the same as 
an allocation based on closing the books.
    Example 4. Net operating loss. P sells all of T's stock to X, T 
becomes a nonmember on June 30 of Year 1, and ratable allocation 
under paragraph (b)(2)(ii) of this section is elected. Under ratable 
allocation, the X group has a $100 consolidated net operating loss 
for Year 1, all of which is attributable to T. However, because of 
extraordinary items, T has $100 of income for the portion of Year 1 
that T is a member of the P group. Under paragraph (b)(2)(ii)(B)(2) 
of this section, T's loss may be carried back from the X group to 
the portion of Year 1 that T was a member of the P group. See also 
section 172 and Sec. 1.1502-21(b). Under paragraph (b)(2)(ii)(C)(5) 
of this section, any item carried to or from any portion of the 
original year is an extraordinary item, and the loss therefore is 
not taken into account again in determining the ratable allocation 
under paragraph (b)(2)(ii) of this section.
    Example 5. Employee benefit plans. (a) Facts. P sells all of T's 
stock to X, and T becomes a nonmember on June 30 of Year 1. On March 
15 of Year 2, T contributes $100 to its retirement plan, which is a 
qualified plan under section 401(a). T is not required to make 
quarterly contributions to the plan for Year 1 under section 412(m). 
The contribution is made on account of T's taxable period beginning 
on July 1 of Year 1, and is deemed in accordance with section 
404(a)(6) to have been made on the last day of T's taxable period 
beginning on July 1 of Year 1. Ratable allocation under paragraph 
(b)(2)(ii) of this section is not elected.
    (b) Analysis. Under paragraph (b) of this section, the sale is 
treated as causing T's tax year to end on June 30, and the period 
beginning on July 1 is treated as a separate annual accounting 
period for all Federal income tax purposes. T's income from January 
1 to June 30 is included in the P group's Year 1 return, and T's 
income from July 1 to December 31 is included in the X group's Year 
1 return. Thus, the $100 contribution is deductible by T for the 
period of Year 1 that it is a member of the X group, subject to the 
applicable limitations of section 404, if a contribution on the last 
day of that period would otherwise be deductible.
    (c) The facts are the same as in paragraph (a) of this Example 
5, except that, in accordance with section 404(a)(6), $40 of the 
$100 contribution is made on account of T's taxable period beginning 
on January 1 of Year 1 and is deemed to be made on the last day of 
T's taxable period beginning on January 1 of Year 1. The remaining 
$60 is made on account of T's taxable period beginning on July 1 of 
Year 1 and is deemed to be made on the last day of T's taxable 
period beginning on July 1 of Year 1. As in paragraph (b) of this 
Example 5, under paragraph (b) of this section, the sale is treated 
as causing T's tax year to end on June 30, and the period beginning 
on July 1 is treated as a separate annual accounting period for all 
Federal income tax purposes. The $40 portion of the contribution is 
deductible by T for the period of Year 1 that it is a member of the 
P group, subject to the applicable limitations of section 404 and 
provided that a $40 contribution on the last day of that period 
would otherwise be deductible for that period, and the $60 portion 
is deductible by T for the period of Year 1 that it is a member of 
the X group, subject to the same conditions.
    (d) Ratable allocation. The facts are the same as in paragraph 
(a) of this Example 5, except that P, T, and X elect ratable 
allocation under paragraph (b)(2)(ii) of this section and T's 
deduction for the retirement plan contribution is not an 
extraordinary item. T's deduction may be ratably allocated, subject 
to the applicable limitations of section 404, and is allowable only 
if a contribution on the last day of Year 1 otherwise would be 
deductible for any period in the year. (The results would be the 
same if S were an unaffiliated corporation when acquired by X, and 
the due date of its last separate return (including extensions) were 
before the pension contribution was made on March 15 of Year 2.)
    Example 6. Allocation of partnership items. (a) Facts. P sells 
all of T's stock to X, and T becomes a nonmember on June 30 of Year 
1. T has a 10% interest in the capital and profits of a calendar-
year partnership.
    (b) Analysis. Under paragraph (b)(2)(v)(A) of this section, T is 
treated, solely for purposes of determining T's tax year in which 
the partnership's items are included, as selling or exchanging its 
entire interest in the partnership as of P's sale of T's stock. 
Thus, the deemed disposition is not taken into account under section 
708, it does not result in gain or loss being recognized by T, and 
T's holding period is unaffected. However, under section 706(a), in 
determining T's income, T is required to include its distributive 
share of partnership items for the partnership's year ending within 
or with T's tax year. Under section 706(c)(2), the partnership's tax 
year is treated as closing with respect to T for this purpose as of 
P's sale of T's stock. The allocation of T's distributive share of 
partnership items must be made under Sec. 1.706-1(c)(2)(ii).
    (c) Controlled partnership. The facts are the same as in 
paragraph (a) of this Example 6, except that T has a 75% interest in 
the capital and profits of the partnership. Under paragraph 
(b)(2)(v)(B) of this section, T's distributive share of the 
partnership's items is treated as T's items for purposes of 
paragraph (b)(2) of this section. Thus, if ratable allocation under 
paragraph (b)(2)(ii) of this section is not elected, T's 
distributive share of the partnership's items must be determined 
under Sec. 1.706-1(c)(2)(ii) by an interim closing of the 
partnership's books. Similarly, if ratable allocation is elected for 
T's items that are not extraordinary items, T's distributive share 
of the partnership's nonextraordinary items must also be ratably 
allocated under Sec. 1.706-1(c)(2)(ii).

    (5) Effective date--(i) General rule. This paragraph (b) applies to 
corporations becoming or ceasing to be members of consolidated groups 
on or after January 1, 1995.
    (ii) Prior law. For prior transactions, see prior regulations under 
section 1502 as in effect with respect to the transaction. See, e.g., 
Sec. 1.1502-76(b) and (d) as contained in the 26 CFR part 1 edition 
revised as of April 1, 1994. However, Sec. 1.1502-76(b)(5) and (6) as 
contained in the 26 CFR part 1 edition revised as of April 1, 1994 do 
not apply with respect to corporations becoming or ceasing to be 
members of consolidated groups on or after January 1, 1995. If both 
this paragraph (b) and prior law may apply to determine the inclusion 
of any amount in a return, appropriate adjustments must be made to 
prevent the omission or duplication of the amount.
* * * * *
    Par. 19. Section 1.1502-80 is amended by adding paragraphs (c) and 
(d) to read as follows:


Sec. 1.1502-80  Applicability of other provisions of law.

* * * * *
    (c) Deferral of section 165. For consolidated return years 
beginning on or after January 1, 1995, stock of a member is not treated 
as worthless under section 165 before the stock is treated as disposed 
of under the principles of Sec. 1.1502-19(c)(1)(iii). See Secs. 1.1502-
15(b) and 1.1502-20 for additional rules relating to stock loss.
    (d) Non-applicability of section 357(c)--(1) In general. Section 
357(c) does not apply to any transaction to which Sec. 1.1502-13, 
Sec. 1.1502-13T, Sec. 1.1502-14, or Sec. 1.1502-14T applies, if it 
occurs in a consolidated return year beginning on or after January 1, 
1995. For example, P, S, and T are members of a consolidated group, P 
owns all of the stock of S and T with bases of $30 and $20, 
respectively, S has a $30 basis in its assets and $40 of liabilities, 
and S merges into T in a transaction described in section 368(a)(1)(A) 
(and in section 368(a)(1)(D)); section 357(c) does not apply to the 
merger, P's basis in T's stock increases to $50 ($30 plus $20), and T 
succeeds to S's $30 basis in the assets transferred subject to the $40 
liability. Similarly, if S instead transferred its assets and 
liabilities to a newly formed subsidiary in a transaction to which 
section 351 applies, section 357(c) does not apply and S's basis in the 
subsidiary's stock is a $10 excess loss account. This paragraph (d) 
does not apply to a transaction if the transferor or transferee becomes 
a nonmember as part of the same plan or arrangement. The transferor (or 
transferee) is treated as becoming a nonmember once it is no longer a 
member of a consolidated group that includes the transferee (or 
transferor).
    (2) Prior period transactions. If, in a tax year beginning before 
January 1, 1995, a member's stock with an excess loss account is 
transferred in a transaction to which Sec. 1.1502-13, Sec. 1.1502-13T, 
Sec. 1.1502-14, or Sec. 1.1502-14T applies, paragraph (d)(1) of this 
section applies to the stock transfer to the extent that the income, 
gain, deduction, or loss (if any) is not taken into account in a tax 
year beginning before January 1, 1995. For example, if P, S, and T, are 
members of a consolidated group, T's stock has an excess loss account, 
and P transfers the T stock to S in 1993 in a transaction to which 
section 351 and Sec. 1.1502-13 apply, section 357(c) applies to the 
transfer only to the extent P's gain is taken into account in tax years 
beginning before January 1, 1995.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT 
    Par. 20. The authority citation for Part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805. 
Sec. 602.101  [Amended]

    Par. 21. Section 602.101(c) is amended by removing the entries for 
Secs. 1.1502-31T, 1.1502-32T, and 1.1502-33T from the table, adding in 
numerical order, the entry for Sec. 1.1502-31, and revising the entries 
for Secs. 1.1502-32, 1.1502-33, and 1.1502-76.

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
                                                                        
                                  *****                                 
1.1502-31..................................................    1545-1344
1.1502-32..................................................    1545-1344
1.1502-33..................................................    1545-1344
                                                                        
                                  *****                                 
1.1502-76..................................................    1545-1344
                                                                        
                                  *****                                 
------------------------------------------------------------------------


    Approved: June 29, 1994.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Cynthia G. Beerbower,
Deputy Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 94-19548 Filed 8-12-94; 8:45 am]
BILLING CODE 4830-01-U