[Federal Register Volume 64, Number 153 (Tuesday, August 10, 1999)]
[Proposed Rules]
[Pages 43462-43503]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-19930]



[[Page 43461]]

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Part III





Department of the Treasury





_______________________________________________________________________



Internal Revenue Service



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26 CFR Parts 1 and 602



Purchase Price Allocations in Deemed Actual Asset Acquisitions; 
Proposed Rule

  Federal Register / Vol. 64, No. 153 / Tuesday, August 10, 1999 / 
Proposed Rules  

[[Page 43462]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[REG-107069-97]
RIN 1545-AZ58


Purchase Price Allocations in Deemed Actual Asset Acquisitions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
allocation of purchase price in deemed and actual asset acquisitions. 
The proposed regulations determine the amount realized and the amount 
of basis allocated to each asset transferred in a deemed or actual 
asset acquisition and affect transactions reported on either Form 8023 
or Form 8594.

DATES: Written comments must be received by September 20, 1999. 
Requests to speak and outlines of topics to be discussed at the hearing 
scheduled for 10 a.m., October 12, 1999, must be received by September 
20, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG 107069 97), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R (REG 
107069 97), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the Internet by selecting the ``Tax Regs'' 
option on the IRS Home Page, or by submitting comments directly to the 
IRS Internet site at http://www.irs.ustreas.gov/tax__regs/
regslist.html. The public hearing will be held in the NYU Classroom, 
Room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Richard 
Starke, (202) 622-7790 or Stephen R. Wegener, (202) 622-7530; 
concerning submissions of comments, the hearing, and/or to be placed on 
the building access list to attend the hearing, Guy R. Traynor (202) 
622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)).
    Comments on the collections of information should be sent 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, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224. 
Comments on the collections of information should be received by 
October 12, 1999.
    Comments are specifically requested concerning:
    Whether the proposed collections of information are necessary for 
the proper performance of the functions of the IRS, including whether 
the collections will have a practical utility;
    The accuracy of the estimated burden associated with the proposed 
collections of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collections of information in these proposed regulations are in 
Secs. 1.338-2(d), 1.338-2(e)(4), 1.338-5(d)(3), 1.338-10(a)(4), 
1.338(h)(10)-1(d)(2), and 1.1060-1(e)(ii)(A) and (B). The collections 
of information are necessary to make an election to treat a sale of 
stock as a sale of assets, to calculate and collect the appropriate 
amount of tax in a deemed or actual asset acquisition, and to determine 
the bases of assets acquired in a deemed or actual asset acquisition.
    These collections of information are required to obtain a benefit. 
The likely respondents and/or recordkeepers are small businesses or 
organizations, businesses, or other for-profit institutions, and farms.
    The regulation provides that a section 338 election is made by 
filing Form 8023. The burden for this requirement is reflected in the 
burden of Form 8023. The regulation also provides that both a seller 
and a purchaser must each file an asset acquisition statement on Form 
8594. The burden for this requirement is reflected in the burden of 
Form 8594. The burden for the collection of information in Sec. 1.338-
2(e)(4) is as follows:

Estimated total annual reporting/recordkeeping burden: 25 hours.
Estimated average annual burden per respondent/recordkeeper: 0.56 
hours.
Estimated number of respondents/recordkeepers: 45.
Estimated annual frequency of responses: On occasion.

    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

A. Evolution of Code and Regulations

    Section 338 was added to the Internal Revenue Code of 1954 (Code) 
by section 224(a) of the Tax Equity and Fiscal Responsibility Act of 
1982, Public Law 97-248 (96 Stat. 324), and amended by section 
306(a)(8) of the Technical Corrections Act of 1982, Public Law 97-448 
(96 Stat. 2365), and further amended by section 712(k) of the Tax 
Reform Act of 1984, Public Law 98-369 (98 Stat. 951). Section 338 
replaces any nonstatutory treatment of a stock purchase as an asset 
purchase by allowing certain acquiring corporations to elect to treat 
qualifying stock purchases as asset acquisitions.
    General rules for making elections under section 338 were first 
issued in temporary regulations Secs. 5f.338-1, 5f.338-2, and 5f.338-3 
published as TD 7942 in the Federal Register on February 8, 1984 (49 FR 
4722) (1984-1 C.B. 93). Those rules were amended and redesignated as 
Secs. 1.338-1T, 1.338-2T, and 1.338-3T by temporary regulations 
published as TD 7975 in the Federal Register on September 6, 1984 (49 
FR 35086) (1984-2 C.B. 81).
    Treasury Decision 8021, published in the Federal Register on April 
25, 1985 (50 FR 16402) (1985-1 C.B. 96), amended Secs. 1.338-1T and 
1.338-2T and added Sec. 1.338-4T. These regulations provided guidance 
in a question and answer format, most notably in the areas of asset and 
stock consistency requirements.
    Temporary regulations published as TD 8068 in the Federal Register 
on January 8, 1986 (51 FR 741) (1986-1 C.B. 165) amended Secs. 1.338-1T 
and

[[Page 43463]]

1.338-4T. The temporary regulations published on January 8, 1986 also 
added Sec. 1.338(h)(10)-1T to implement section 338(h)(10), under which 
a selling consolidated group can elect to treat certain stock sales as 
asset sales.
    Sections 1.338-1T and 1.338-4T were again amended by temporary 
regulations published as TD 8072 in the Federal Register on January 29, 
1986 (51 FR 3583) (1986-1 C.B. 111) (Due to typesetting errors, the 
Federal Register republished TD 8072 in its entirety on March 28, 1986 
(51 FR 10617)). The temporary regulations published on January 29, 1986 
also amended Sec. 1.338(h)(10)-1T and added Secs. 1.338(b)-1T, 
1.338(b)-22T, and 1.338(b)-3T. These regulations required the selling 
price and basis allocated to each asset to be determined by using a 
four class residual method.
    On February 12, 1986, temporary regulations published as TD 8074 in 
the Federal Register (51 FR 5163) (1986-1 C.B. 126) amended 
Secs. 1.338-1T, 1.338-4T, and 1.338(h)(10)-1T and added Sec. 1.338-5T. 
These regulations provided guidance on international aspects of section 
338.
    Sections 1.338-1T, 1.338-2T, 1.338-4T, 1.338-5T, and 1.338(h)(10)-
1T were amended by temporary regulations published as TD 8088 in the 
Federal Register on May 16, 1986 (51 FR 17929) (1986-1 C.B. 103). 
Sections 1.338-1T, 1.338-3T, 1.338-4T, 1.338-5T, and 1.338(h)(10)-1T 
were amended by temporary regulations published as TD 8092 in the 
Federal Register on July 1, 1986 (51 FR 23741) (1986-2 C.B. 49). The 
temporary regulations published on July 1, 1986 also added 
Sec. 1.338(b)-4T. These regulations made miscellaneous conforming 
changes and transitional rules relating to making and filing section 
338 elections.
    Section 1060 was added by section 641 of the Tax Reform Act of 
1986, Public Law 99-514 (100 Stat. 2282). Section 1060 requires both 
the buyer and the seller of a trade or business to allocate their 
consideration paid or received to the assets under the same residual 
method prescribed by the section 338 regulations. Also as part of the 
1986 act, miscellaneous changes were made to section 338 by section 
631, 1275, 1804(e), and 1899A (100 Stat. 2269, 2598, 2800, 2958). The 
changes to section 338 were made to conform section 338 with the repeal 
of the General Utilities doctrine and to define a qualified stock 
purchase by reference to section 1504.
    General guidance under section 1060 was provided by Sec. 1.1060-1T, 
added by temporary regulations published as TD 8215 on July 18, 1986 
(53 FR 27035) (1988-2 C.B. 304). These regulations included direction 
on the scope of section 1060 and reiterated the four class residual 
method found in the section 338 regulations.
    Section 1060 was amended by section 1006(h) of the Technical and 
Miscellaneous Revenue Act of 1988, Public Law 100-647 (102 Stat. 3410). 
This amendment requires the residual method to be used in the case of a 
distribution of partnership property or a transfer of an interest in a 
partnership, but only in determining the value of goodwill or going 
concern value for purposes of applying section 755. Miscellaneous 
changes were again made to section 338 by sections 1006(e)(20), 
1012(bb)(5)(A), and 1018(d)(9) of the 1988 act (102 Stat. 3403, 3535, 
3581).
    Sections 338 and 1060 were amended by section 11323 of the Omnibus 
Budget Reconciliation Act of 1990, Public Law 101-508 (104 Stat. 1388-
464). The amendments add certain reporting requirements under sections 
338 and 1060. In addition, a provision was added to section 1060 under 
which parties are bound by written agreements as to allocations or fair 
market values. The legislative history indicates that the parties are 
so bound unless the parties can refute the agreement under the 
standards set forth in Commissioner v. Danielson, 378 F.2d 771 (3d 
Cir.), cert. denied, 389 U.S. 858 (1967) (by presenting proof which in 
an action between the parties would be admissible to alter that 
construction or to show its unenforceability because of mistake, undue 
influence, fraud, duress, etc.). See, H.R. Ways and Means Comm., 101st 
Cong., 2d Sess. (Print No. 101-37, Oct. 15, 1990), at 79 .
    Temporary regulations published as TD 8339 in the Federal Register 
on March 15, 1991 (56 FR 11093) (1991-1 C.B. 52) added Sec. 1.338-6T. 
The March 15, 1991, temporary regulations provided relief from 
situations in which a corporation making an election under section 338 
could be subjected to multiple taxation on the same gain as a result of 
the 1986 repeal of the General Utilities doctrine.
    On January 12, 1992, a notice of proposed rulemaking (C0-111-90) 
under section 338 was published in the Federal Register (57 FR 1409) 
(1992-1 C.B. 1000). The notice of proposed rulemaking contained 
proposed regulations to replace the question and answer asset and stock 
consistency rules of Sec. 1.338-4T and the rules relating to the 
international aspects of section 338 found in Sec. 1.338-5T. In 
addition, the proposed rules restated the remainder of the temporary 
regulations under section 338, except that only minor conforming 
changes were made to Secs. 1.338(b)-2T and 1.338(b)-3T.
    Section 1060 was again amended by section 13261(e) of the Omnibus 
Budget Reconciliation Act of 1993, Public Law 103-66 (107 Stat. 539). 
This amendment made changes to section 1060 to conform the rules for 
actual asset acquisitions to the amortization of intangibles under 
section 197. In addition, the legislative history to section 197 
suggested that the residual method should be altered to accommodate 
section 197 intangibles (See H.R. Rep. 111, 103d Cong., 1st Sess. 760 
(May 23, 1993) (1993-3 C.B. 336).
    Sections 1.338-1T, 1.338-2T, 1.338-3T, 1.338-4T, 1.338-5T, 
1.338(b)-1T, and 1.338(h)(10)-1T were revised and replaced by 
Secs. 1.338-1, 1.338-2, 1.338-3, 1.338-4, 1.338-5, 1.338(b)-1, and 
1.338(h)(10)-1, respectively, by final regulations published as TD 8515 
in the Federal Register on January 20, 1994 (59 FR 2958) (1994-1 C.B. 
89). The final regulations published on January 20, 1994 (TD 8515) also 
removed Sec. 1.338-6T and added Sec. 1.338(i)-1. Also, a new 
Sec. 1.338-4T was added by temporary regulations published as TD 8516 
on January 20, 1994 in the Federal Register (59 FR 2956) (1994-1 C.B. 
119). The temporary regulations provided consistency rules applicable 
to certain cases involving controlled foreign corporations.
    Treasury Decision 8626 amended Sec. 1.338-2 by final regulations 
published in the Federal Register on October 27, 1995 (60 FR 54942) 
(1995-2 C.B. 34), providing rules governing the treatment of an 
intragroup merger following a qualified stock purchase of target stock 
when a section 338 election is not made for the target.
    Section 1.338-4 was amended and Sec. 1.338-4T was removed by final 
regulations published as TD 8710 in the Federal Register on January 23, 
1997 (62 FR 3458) (1997-1 C.B. 82).
    Sections 1.338(b)-2T, 1.338(b)-3T, and 1.1060-1T were amended by 
temporary regulations published as TD 8711 in the Federal Register on 
January 16, 1997 (62 FR 2267) (1997-1 C.B. 85). The January 16, 1997, 
changes to the regulations adapted the residual method to section 197 
by adding a fifth class to the residual method prescribed for deemed 
and actual asset acquisitions.

B. Current Regulations

    Section 338 allows certain purchasers of stock to treat the 
purchases instead as purchases of assets. A purchasing corporation can 
elect to treat a stock acquisition as an asset acquisition if it 
acquires 80 percent of the total voting

[[Page 43464]]

power and 80 percent of the total value of the stock of a target 
corporation (not taking into account certain preferred stock) by 
purchase within a 12-month period. If a purchasing corporation makes a 
section 338 election, the target is treated as if it (as old target) 
sold all of its assets at the close of the acquisition date at fair 
market value in a single transaction and (as new target) purchased all 
of the assets as of the beginning of day after the acquisition date.
    If a purchasing corporation acquires the stock of a target 
corporation in a qualified stock purchase and makes a section 338(g) 
election (i.e., makes a general section 338 election, not a section 
338(h)(10) election), old target's gain or loss from the deemed asset 
sale is included in old target's final return unless old target is a 
member of a consolidated group or is an S corporation. In the 
consolidated and S corporation cases, old target files a special final 
return including only the items from the deemed asset sale. Sec. 1.338 
1(e). In the consolidated case, that return is consolidated with 
neither the selling corporation's nor the purchasing corporation's 
consolidated group. In the S corporation case, old target must file the 
special final return as a C corporation. The section 338(g) election 
(as opposed to a section 338(h)(10) election) generally does not change 
the tax treatment of the selling shareholders--that is, they are still 
taxed on their stock sale, notwithstanding the purchasing corporation's 
section 338(g) election.
    In certain cases, the selling shareholders may join with the 
purchasing corporation in making a section 338(h)(10) election. Until 
1994, a section 338(h)(10) election could be made only for target 
corporations that were members of a consolidated group. The 1994 
revisions to the section 338 regulations (effective retroactively to 
1992 at taxpayers' election) expanded the eligibility for section 
338(h)(10) elections to target corporations that are members of an 
affiliated group and S corporations. The section 338(h)(10) election 
changes the tax treatment of old target and the selling shareholders. 
Old target is deemed to sell all its assets in a single transaction 
while a member of the selling consolidated group (or while a non-
consolidated affiliate, or while an S corporation owned by the selling 
shareholders) and is deemed immediately thereafter to distribute the 
proceeds in complete liquidation to the members of the selling 
consolidated group who sold the target stock (or to the selling 
affiliate or to all the S corporation shareholders). Thus, under 
section 338(h)(10), the selling shareholders are not treated as selling 
stock but instead realize gain or loss, if any, on the stock in the 
deemed liquidation. Sec. 1.338(h)(10)-1(d)(2). Usually, a selling 
consolidated group or selling affiliate will recognize no stock gain or 
loss on the deemed liquidation under section 332. S corporation 
shareholders will include their share of items of income, gain, loss, 
or deduction on the deemed asset sale passed through to them under 
section 1366, increase or decrease their basis accordingly under 
section 1367, and then recognize any remaining gain or loss in their 
stock under section 331 (the overall effect of which is to recognize 
net gain or loss equal to the amount of built-in gain or loss in their 
S corporation stock immediately before the qualified stock purchase).
    In the case of a section 338(g) election, old target's total amount 
realized for the assets it is deemed to sell (aggregate deemed sale 
price or ADSP) is the sum of (a) the purchasing corporation's grossed-
up basis in recently purchased target stock; (b) the liabilities of new 
target; and (c) other relevant items. This is the amount to be 
allocated among the assets sold for purposes of determining gain or 
loss on the assets. Sec. 1.338-3(d)(1) and (2). The liabilities 
referred to in (b) are those liabilities assumed by new target, but the 
amount thereof taken into account in ADSP is determined as if old 
target had sold its assets to an unrelated person for consideration 
that included the liabilities. The liabilities include any tax 
liability resulting from the deemed asset sale. Secs. 1.338-3(d)(3) and 
1.338(b)-1(f). In the case of a section 338(h)(10) election, ADSP is 
modified. While not stated explicitly, modified ADSP (MADSP) appears to 
exclude any tax liabilities resulting from the deemed asset sale. 
Sec. 1.338(h)(10)-1(f).
    New target's adjusted grossed-up basis in the assets it is deemed 
to purchase (AGUB) is the sum of (a) the purchasing corporation's 
grossed-up basis in recently purchased target stock; (b) the purchasing 
corporation's basis in nonrecently purchased target stock; (c) the 
liabilities of new target; and (d) other relevant items. This is the 
amount to be allocated among the assets sold for purposes of 
determining the purchaser's basis in the assets. Sec. 1.338(b)-1(c)(1).
    Section 1060(a) requires a purchaser and a seller to allocate basis 
for any applicable asset acquisition in the same manner as amounts are 
allocated to such assets under section 338(b)(5). Section 1060(c) 
defines an applicable asset acquisition as any transfer of assets that 
constitute a trade or business where the transferee's basis is 
determined wholly by reference to the consideration paid for the 
assets.
    Section 338(b)(5) authorizes the Secretary to issue regulations 
prescribing how the deemed purchase price is to be allocated among the 
assets. Final and temporary regulations under sections 338(b) and 1060, 
as amended, implement this authority. The regulations generally require 
that the basis of the acquired (or deemed acquired) assets will be 
determined using a five class residual method. Class I consists of cash 
and cash equivalents; Class II consists of certificates of deposit, 
U.S. Government securities, readily marketable stock or securities, and 
foreign currency; Class III includes all assets not included in Class 
I, Class II, Class IV, or Class V; Class IV consists of section 197 
intangible assets except those in the nature of goodwill and going 
concern value; and Class V consists of section 197 intangible assets in 
the nature of goodwill and going concern value. The total allocable 
basis is first decreased by the amount of Class I assets. Any remaining 
amount is allocated proportionally to Class II assets to the extent of 
their fair market value. Any remaining amount is then allocated first 
to Class III assets and then to Class IV assets in the same manner as 
to Class II assets. Finally, any remaining amount is allocated to the 
Class V assets. See Secs. 1.338(b)-2T and 1.1060-1T.

Reasons for Change

A. In General

    The regulations under section 338 have developed, in large part, 
through a series of small changes and additions according to the 
priorities of taxpayers' and the government's needs and in response to 
statutory amendments to section 338 or other relevant Code sections. 
Most of the regulations under section 338 (Secs. 1.338-1, 1.338-2, 
1.338-3, 1.338-4, 1.338-5, 1.338(b)-1, 1.338(h)(10)-1, and 1.338(i)-1) 
were made final as part of a single package as recently as 1994, but, 
with the exception of the consistency rules, most of those regulations 
were largely restatements of the existing temporary regulations that 
had been developed to that point. The remaining temporary regulations 
under section 338 and the temporary regulations under section 1060 have 
been substantively changed only once since 1986 and 1988, respectively, 
to accommodate the addition of section 197 to the Code. As a result of 
the ad hoc manner in which the regulations under sections 338 and 1060 
have been amended, the current regulations are

[[Page 43465]]

difficult to follow. Thus the IRS and Treasury determined that a review 
of the regulations was appropriate.
    In addition, the current regulations have proven problematic in 
three major respects: first, in their statement of tax accounting rules 
and their relationship to tax accounting rules for asset purchases 
outside of section 338, second, in the effects of the allocation rules, 
and, third, in their lack of a statement of a complete model for the 
deemed asset sale (and, in the case of section 338(h)(10) elections, 
the deemed liquidation) from which one can determine the tax 
consequences not specifically set forth in the regulations.

B. Tax Accounting Rules Under Current Regulations

    The current regulations include certain rules for accounting for 
items in connection with the deemed asset sale. These tax accounting 
rules apply for determining the original amounts of and subsequent 
adjustments to ADSP and AGUB. For example, the regulations provide 
rules governing the treatment of contingent liabilities deemed assumed 
by new target. In some respects the tax accounting rules in the current 
regulations differ considerably from the tax accounting rules 
applicable to actual asset sales.
Link Between Old Target's and New Target's Tax Accounting
    Under the current regulations, ADSP is defined as the sum of (a) 
the grossed-up basis of the purchasing corporation's recently purchased 
target stock, (b) the liabilities of new target, and (c) other relevant 
items. Thus, the calculation of ADSP is linked to the tax accounting 
treatment of new target or the purchaser of new target in item (a) 
above. Such link does not exist, however, in the case of an actual 
asset sale between two parties. In actual asset sales the timing and 
amount of the seller's amount realized and the timing and amount of the 
buyer's basis may differ. For example, with respect to the link under 
(a), the current fair market value of promised future contingent 
payments that constitute debt is taken into account in amount realized 
under Sec. 1.1001-1(g) unless, in rare and extraordinary circumstances, 
the fair market value is not reasonably ascertainable. Yet, under 
Sec. 1.1012-1(g), the current fair market value of such future 
contingent payments is not taken into account currently in the 
purchaser's basis.
    This link between old target's deemed sales price and the 
purchasing corporation's basis in target stock existed in the original 
version of section 338, adopted in 1982. In 1984, Congress removed that 
link from the statute, providing instead that old target should be 
deemed to sell its assets at fair market value. The regulations 
originally allowed old target to choose between using the three-part 
formula (items (a) through (c)) above to calculate ADSP and treating 
the assets as being sold at their fair market value. In 1994, new 
regulations eliminated the election, thereafter requiring use of the 
three-part formula. Under the current regulations, any contingent 
payments for target stock do not become part of AGUB and ADSP until 
they become fixed and determinable. However, no rule prevents the 
seller from using all its basis to offset the amount realized in the 
year of the deemed sale. As a result of the link between old target's 
deemed sales price and the purchasing corporation's purchase price, old 
target receives open transaction treatment on terms broader than those 
available in an actual asset sale. Compare Sec. 15A.453-1(d)(2)(iii) 
(``Only in those rare and extraordinary cases involving sales for a 
contingent payment obligation in which the fair market value of the 
obligation * * * cannot reasonably be ascertained will the taxpayer be 
entitled to assert that the transaction is `open.' '')
Liabilities Assumed
    The current regulations specify new target's tax accounting 
treatment for the assumption of liabilities. New target takes a 
liability into account in AGUB only if it is a bona fide liability of 
target as of that date that would be properly taken into account in 
basis under principles of tax law if new target had acquired old 
target's assets from an unrelated person and, as part of the 
transaction, had assumed, or taken property subject to, the 
liabilities, and the amount thereof is determined on the same basis. 
Sec. 1.338(b)-1(f)(1) and (2).
    Under Sec. 1.338(b)-3T(a)(1), AGUB is subsequently redetermined 
only if an adjustment would be required, under general principles of 
tax law, in connection with an actual asset purchase by new target from 
an unrelated person. One of the subsequent events enumerated as an 
example is the change in a contingent liability of target to one which 
is fixed and determinable. Section 1.338(b)-3T(c)(1) provides that a 
contingent amount (including contingent liabilities of old target 
deemed assumed) is taken into account at the time at which such amount 
becomes fixed and determinable. The statement of the latter rule 
suggests to some that it overrides the rules based on general 
principles of tax law stated in Secs. 1.338(b)-1(f)(2) and 1.338(b)-
3T(a)(1). However, interpreting the fixed and determinable rule in this 
manner would be inconsistent with the economic performance rules of 
section 461(h), that, in some circumstances, would operate to defer new 
target's taking an assumed liability into account until some time after 
the liability becomes fixed and determinable. See Secs. 1.461-4(a) and 
1.446-1(c)(1)(ii)(B).
Installment Method
    The current regulations provide no rules for old target to report 
its deemed sale gain under the installment method. Because the parties 
could have structured an actual asset sale to qualify for the 
installment method, commentators have argued that making the 
installment method available when a section 338(h)(10) election is made 
would be consistent with the full asset sale model implied by those 
rules. Making the installment method available when only a section 
338(g) election is made would not be appropriate because the target 
shareholders are still treated as selling stock and because target 
would get a step-up in basis of assets before it had borne the tax 
burden for such step-up.

C. Allocation Rules Under Current Regulations

Fast Pay Assets
    The current regulations employ a residual method of allocation. 
Under the residual method, the amount of basis to be allocated to 
goodwill and going concern value is based entirely on the amount of 
basis remaining to be allocated after all other assets have been 
allocated basis to the extent of their fair market values. Because 
assets other than goodwill and going concern value tend to be more 
easily valued, the residual allocation method is intended to result in 
less controversy over the value of goodwill and going concern value. 
The legislative history of section 1060, adopted in the Tax Reform Act 
of 1986, Public Law 99-514, (100 Stat. 2282), noted with approval the 
use of the residual method under the section 338(b) regulations and 
required that the same method be used in regulations to be prescribed 
under section 1060. See S. Rep. No. 313, 99th Cong., 2d Sess., May 29, 
1986, at 254. Accordingly, the current regulations place each acquired 
asset into one of five asset classes. The total allocable basis is 
allocated among the classes starting with the first class and 
proceeding to the final, residual class. No asset in any class except 
for the residual class can be allocated more than its fair market 
value. If the aggregate basis allocable to a particular

[[Page 43466]]

class is less than the aggregate fair market value of the assets within 
the class, each asset is allocated an amount in proportion to its fair 
market value and nothing is allocated to any junior class.
    The residual allocation method presents unique problems when the 
cost of the assets, and hence the basis to be allocated thereto, is 
less than the aggregate fair market value of the individual assets. 
This situation may arise as a result of the use of contingent 
consideration for target stock or the deemed assumption of liabilities 
that are not yet taken into account. If this is the case, the basis of 
the assets is said to be impaired. Under the residual method, the 
impairment is borne equally by the assets in the first class in which 
the cumulative fair market value exceeds the remaining aggregate basis 
available for allocation. As no basis is allocated to assets in junior 
classes, they are also impaired. If such an asset is sold, the taxpayer 
will realize a gain on its disposition even if its value has not 
increased since the acquisition date. Taxpayers may reverse the gain 
recognized in later years if the purchasing corporation pays or incurs 
additional amounts for target stock or additional target liabilities 
deemed assumed are taken into account. For this reason, the gain 
recognized is often referred to as phantom income.
    The problem is most acute with assets that turn over quickly, such 
as accounts receivable and inventory (fast pay assets). Comments 
received on the temporary regulations suggested that fast pay assets 
should be placed in a more senior class to make it more likely that 
basis is allocated equal to the assets' fair market values in order to 
alleviate concerns over phantom income.
Top-Down Allocation
    Under the current regulations, stock in a subsidiary is generally a 
Class III asset. In allocating basis among tiered corporations, an 
allocation to the stock of a subsidiary becomes the starting point for 
allocation to the assets inside the subsidiary if a section 338 
election is also made for the subsidiary. See, e.g., Sec. 1.338-2(b)(4) 
of the current regulations. One might refer to this as top-down 
allocation. Under a top-down allocation, the basis of assets of a 
particular class can be more impaired at one corporate level than at 
another. For example, Class III assets in the parent target corporation 
might be allocated some basis while Class II assets in its subsidiary 
are allocated no basis because Class I assets in the subsidiary have 
absorbed all the basis allocated to the stock in the subsidiary, a 
Class III asset. The differences in impairment arising from the 
differences in the location of assets and liabilities is inconsistent 
with the residual method (e.g., liabilities secured by an asset support 
basis of all assets in a single corporation) and can lead to the 
misallocation of basis.

D. Statement of Complete Model

    For purposes of effectuating the statutory purpose of permitting 
taxpayers to elect to treat a stock acquisition as an asset 
acquisition, section 338 and the current regulations deem certain 
transactions to occur. The current regulations' express statement of 
these deemed transactions provides the appropriate Federal income tax 
consequences for most targets for which a section 338 election is made. 
However, as with the tax accounting rules, some taxpayers interpret the 
express statements in the current regulations as resulting in tax 
consequences different from those had they actually engaged in the 
transactions deemed under the regulations to have occurred or as 
resulting in the tax consequences specifically stated and not any of 
the collateral consequences.

Explanation of Provisions

A. Overview of Changes

    The proposed regulations are intended to clarify the treatment of, 
and provide consistent rules (where possible) for, both deemed and 
actual asset acquisitions under sections 338 and 1060. In addition, the 
proposed regulations propose changes to the current regulations to take 
into account changes to the tax law made since the different portions 
of the current regulations were published. The changes made by the 
proposed regulations have four major components: organization of the 
regulations; clarification and modification of the accounting rules 
applicable to deemed and actual asset acquisitions; modifications to 
the residual method mandated for allocating consideration and basis; 
and miscellaneous revisions to the current regulations. These changes 
are discussed in the order in which they arise in the proposed 
regulations. The IRS and Treasury did not address any provisions of the 
regulations relating to the consistency rules or the international 
aspects of section 338.

B. Organization of Regulations

    The proposed regulations change the organization of the regulations 
in order to make the rules for all asset acquisitions more 
administrable and provide consistent treatment, when appropriate, for 
deemed and actual asset acquisitions. In order to make the regulations 
more administrable, the proposed regulations redesignate certain of the 
final regulations and reorganize and restate the remaining final and 
temporary regulations in a manner that is more consistent with the 
approach the IRS and Treasury has taken to drafting regulations in 
other areas. The proposed regulations also attempt to provide similar 
treatment, when appropriate, for deemed and actual asset acquisitions 
by stating the relevant concepts once in the regulations under section 
338 and cross-referencing those rules in Sec. 1.1060-1 of the proposed 
regulations.
    New Sec. 1.338-1 includes a scope statement. Section 1.338-1 also 
addresses the question of to what extent the deemed asset sale and 
other elements of the section 338 regime are considered as actually 
having occurred for purposes of application of other Code sections, 
such as those relating to retirement plan sponsors. Terminology and 
definitions and provisions regarding the mechanics of the section 338 
election of current Sec. 1.338-1 have been moved to new Sec. 1.338-2. 
The return filing rules of current Sec. 1.338-1 have been moved to 
their own section, Sec. 1.338-10. All of the current Sec. 1.338-2 rules 
for qualification for making the section 338 election and rules 
relating to the effect on continuity of proprietary interest have been 
moved to new Sec. 1.338-3.
    The rules defining ADSP, as well as various rules relating to 
taxation of old target, currently in Sec. 1.338-3, are in Sec. 1.338-4 
of the proposed regulations. The rules defining AGUB, currently in 
Sec. 1.338(b)-1, are in Sec. 1.338-5. Current Sec. 1.338(b)-3T sets 
forth the timing of increases or decreases in ADSP and AGUB; these 
timing rules have been moved to new Sec. 1.338-4 (ADSP) and new 
Sec. 1.338-5 (AGUB).
    Current Secs. 1.338-4 and 1.338-5, dealing with consistency and 
with international aspects of section 338, respectively, have been 
renumbered Sec. 1.338-8 and 1.338-9, respectively. The substance of 
these rules has not been addressed in connection with these proposed 
regulations.
    Section 1.338-6 of the proposed regulations addresses allocation of 
ADSP and AGUB among assets, currently covered by Sec. 1.338(b)-2T. The 
rules pertaining to subsequent adjustments to ADSP and AGUB, currently 
in Sec. 1.338(b)-3T, are in Sec. 1.338-7 of the proposed regulations.

[[Page 43467]]

    Section 1.338(h)(10)-1 has not been renumbered.

C. Section 1.338-1  General Principles; Status of Old Target and New 
Target

Regulations' Scope Statement
    The scope statement describes the general model of the deemed asset 
sale and other aspects of the regulations used as the basis for the 
rules in the proposed regulations. This statement of the model should 
assist the reader generally in the correct interpretation and 
application of the regulations. This section also provides that old 
target and new target (as well as any other affected parties, for 
example, when a section 338(h)(10) election is made) are to determine 
the tax consequences as if they had actually engaged in the 
transactions deemed under the section 338 regulations to have occurred. 
Thus, the proposed regulations clarify that old target's deemed asset 
sale may result in tax consequences for old target and new target (such 
as income and deduction) in addition to old target's gain or loss 
realized on its deemed sale of assets. For example, if target is an 
insurance company for which a section 338 election is made, the deemed 
asset sale would be characterized and taxed as an assumption-
reinsurance transaction under applicable Federal income tax law. See 
Sec. 1.817-4(d).
    The proposed regulations make minor amendments to the list of 
sections in subtitle A for purposes of which old target and new target 
are considered the same corporation, notwithstanding the deemed asset 
sale between the two. Such changes generally are with respect to 
retirement plan and similar provisions.
Anti-Abuse Rule
    The proposed regulations incorporate an anti-abuse rule giving the 
Commissioner, for purposes of calculating ADSP and AGUB and allocating 
ADSP and AGUB among assets, the authority under certain circumstances 
(a) to treat as not being part of target's assets those added to the 
pool of target's assets before the deemed asset sale and (b) to treat 
as being part of target's assets those removed from the pool of 
target's assets before the deemed asset sale. The Commissioner's 
authority to treat assets added to the pool as not being part of the 
pool exists when the property is transferred to old target in 
connection with the transactions resulting in the application of the 
residual method if such property is, within 24 months after the deemed 
asset sale, (a) not owned by new target but owned, directly or 
indirectly, by a member of the affiliated group of which new target is 
a member, or (b) owned by new target but held or used to more than an 
insignificant extent in connection with an activity conducted, directly 
or indirectly, by another member of the affiliated group of which new 
target is a member in combination with other property acquired, 
directly or indirectly, from the transferor of the property to old 
target. The Commissioner's authority to treat assets removed from the 
pool as being part of the pool exists where the property is removed in 
connection with the transactions resulting in the application of the 
residual method if the removed property, within 24 months after the 
deemed asset sale, (a) is owned by new target, or (b) is owned, 
directly or indirectly, by a member of the affiliated group of which 
new target is a member and continues after the election to be held or 
used to more than an insignificant extent in connection with one or 
more of the activities of new target.

D. Section 1.338-2  Nomenclature and Definitions; Mechanics of the 
Section 338 Election

Definitions
    Four definitions of terms already used in the current regulations 
have been added to the proposed regulations under section 338. These 
terms are acquisition date asset, deemed asset sale, deemed sale gain, 
and deemed sale return. The scope of some of these terms has been 
expanded from their usage in the current regulations. For example, 
deemed asset sale refers to the transaction deemed under the section 
338 regulations to occur between old target and new target and deemed 
sale gain, refers to, in the aggregate, the Federal income tax 
consequences (generally, the income, gain, deduction, and loss) of the 
deemed asset sale. Deemed sale gain can also refer to the Federal 
income tax consequences of the transfer of a particular individual 
asset in the deemed asset sale. The expanded definition of deemed sale 
gain in conjunction with the rules in Sec. 1.338-7(c) of the proposed 
regulations (Sec. 1.338(b)-3T(h) of the current regulations) provides a 
mechanism for target (or, in the case of a section 338(h)(10) election, 
the member of the selling consolidated group, the selling affiliate, or 
the S corporation shareholders to which such income, loss, or other 
amount is attributable) to report items that are properly taken into 
account after the acquisition date. One such item would be the 
deduction for an assumed liability of old target that it could not 
deduct under its method of accounting on or before the acquisition 
date.
    The definition of purchasing corporation has been clarified to 
include new target (new T) with respect to its deemed purchase of stock 
in its own subsidiary.
    The definition of selling group in Sec. 1.338-2 of the proposed 
regulations and related provisions in Sec. 1.338(h)(10)-1 of the 
proposed regulations provide that a section 338(h)(10) election may be 
made for target notwithstanding that it was at some time during the 
year in which the acquisition date occurs the common parent of its 
affiliated or consolidated group, so long as it is not the common 
parent on the acquisition date.

E. Section 1.338-3  Qualification for the Section 338 Election

More Than a Nominal Amount Paid for Purchase of Stock
    The IRS and Treasury have received many informal comments in which 
guidance was requested on whether a section 338 election may be made 
for a target that is insolvent. In order to have a purchase of a share 
of stock in target, the proposed regulations generally require that 
more than a nominal amount of consideration be paid for the stock. With 
respect to target affiliates, one cannot adequately determine whether 
more than a nominal amount of consideration is paid for the stock 
because the amount paid is not determined in an arm's length 
transaction but instead under the allocation rules of the regulations. 
Consequently, the proposed regulations provide that stock in a target 
affiliate acquired by new target in the deemed asset sale of target's 
own assets is considered purchased if, under general principles of tax 
law, new target is considered to own stock of the target affiliate 
meeting the requirements of section 1504(a)(2), notwithstanding that no 
purchase price may be allocated to target's stock in the target 
affiliate. For a discussion of the tax consequences when a qualified 
stock purchase is made of an insolvent corporation and a section 
338(h)(10) election is made, see the discussion of section 338(h)(10) 
elections later in this preamble.
Time for Testing Relationship
    A section 338 election may be made only with respect to a 
transaction that qualifies as a purchase within the meaning of section 
338(h)(3). Under section 338(h)(3)(iii), the parties to the transaction 
must be unrelated in order for a transaction to qualify as a purchase. 
The statute is unclear,

[[Page 43468]]

however, as to when the relationship between the parties is tested. The 
proposed regulation provides that the relationship is tested 
immediately after the transaction. This rule gives effect to the 
statutory objective of preventing a transferor from obtaining the 
benefits of a section 338 election while retaining a significant 
interest, directly or indirectly, in the property transferred. This 
rule also furthers the statutory objective of affording similar tax 
treatment to section 338 deemed asset sales and actual asset sales. For 
example, under this rule, if an actual sale of assets would qualify as 
a reorganization under section 368(a)(1)(D) (with a carryover of basis 
and other attributes), taxpayers are not able to reach a different 
result by structuring the transaction as a stock sale and electing 
under section 338.

F. Sections 1.338 4 and 1.338 5  Aggregate Deemed Sale Price; Various 
Aspects of Taxation of the Deemed Asset Sale; Adjusted Grossed-up Basis

Breaking the Link Between ADSP and AGUB
    Under the current regulations, the first element in the definition 
of ADSP is the grossed-up basis of the purchasing corporation's 
recently purchased target stock. The combination of the link between 
the definitions of ADSP and AGUB with the rule in the current 
regulations that contingent payments are taken into account in AGUB as 
they become fixed and determinable effectively affords old target open-
transaction treatment, which treatment generally is inconsistent with 
Secs. 15A.453-1(d)(2)(iii) and 1.1001 1(g)(2). The proposed regulations 
remove the link in the current regulations between calculation of the 
first element of ADSP and the purchaser's basis in recently purchased 
target stock.
    The new first element in the calculation of ADSP is the grossed-up 
amount realized on the sale to the purchasing corporation of the 
purchasing corporation's recently purchased target stock. Amount 
realized is determined as if old target itself were the selling 
shareholder. Also, notwithstanding that the sellers of the target 
shares may use the installment method of section 453 to report their 
gain on the stock, old target may not use the installment method in the 
calculation of the first element of ADSP.
Time and Amount Combined
    The proposed regulations provide that general principles of tax law 
apply in determining the timing and amount of the elements of ADSP, and 
that ADSP is redetermined at such time and in such amount as an 
increase or decrease would be required, under general principles of tax 
law, to the individual constituent elements of the definition of ADSP. 
The proposed regulations also provide a parallel rule for AGUB. 
Substantively, the two statements are designed to eliminate special 
accounting rules included in the current section 338 regulations-such 
as the current regulations' fixed and determinable rule for the timing 
of taking into account contingent amounts-and to bring taxation of old 
target's deemed asset sale closer to the taxation of an actual asset 
sale. In contrast to the current regulations, the proposed regulations 
state in one location all the rules for determining ADSP and AGUB.
    Both the breaking of the link between the calculation of ADSP and 
the purchaser's basis in recently purchased stock and the removal of 
the fixed and determinable rule for contingent liabilities may often 
result in increased disparities between ADSP and AGUB.
Liabilities
    The current regulations appear to presume that any tax liability of 
old target incurred on its deemed asset sale is a liability assumed by 
new target if a section 338(h)(10) election is not made but is not a 
liability assumed by new target if a section 338(h)(10) election is 
made. These presumptions apparently required that the definition of 
ADSP be modified in current Sec. 1.338(h)(10)-1. The proposed 
regulations make clear that, whether or not a section 338(h)(10) 
election is made, old target's tax liability is deemed not assumed by 
new target only if the parties have agreed that (or the tax or non-tax 
rules operate such that) the seller, and not target, will bear the 
economic cost of that tax liability. This is because the legal burden 
for the tax would otherwise remain with target. Thus, the proposed 
regulations remove the term MADSP from Sec. 1.338(h)(10)-1, and extend 
the use of the term ADSP to that regulation.
    Under the proposed regulations, the amount of liabilities of old 
target taken into account to calculate ADSP is determined as if old 
target had sold its assets to an unrelated person for consideration 
that included the unrelated person's assumption of, or taking subject 
to, the liabilities. Similarly, they provide that, in order to be taken 
into account in AGUB, a liability must be a liability of target that is 
properly taken into account in basis under general principles of tax 
law that would apply if new target had acquired its assets from an 
unrelated person for consideration that included the assumption of, or 
taking subject to, the liability. Regarding the timing of taking such 
liabilities into account, the proposed regulations provide that general 
principles of tax law apply in determining the timing and amount of the 
elements of ADSP and AGUB. Thus, for example, under general principles 
of tax law, a particular liability might not be taken into account in 
basis when a purchaser buys an asset subject to such liability, but 
might be taken into account at some later date; such timing controls 
the timing of including the liability in AGUB. Accordingly, the current 
rule in the regulations that liabilities are taken into account in 
calculating AGUB, and apparently ADSP, only when such liabilities 
become fixed and determinable is removed in the proposed regulations.
Costs
    The treatment of selling costs for old target and acquisition costs 
for new target is modified. For old target, it is made clear that when 
grossing-up the selling shareholders' amount realized where not all the 
target stock is recently purchased by the purchaser, the amount of 
selling costs by which that grossed-up amount realized is reduced is 
not itself grossed-up. For new target, the definition of AGUB is 
changed such that when the purchaser's basis in recently purchased 
stock is grossed-up, acquisition costs are no longer also grossed-up.
    Grossing-up the selling shareholders' selling costs or the 
purchasing corporation's acquisition costs would result in costs not 
actually incurred reducing old target's amount realized for the assets 
or increasing new target's cost basis in the assets. The IRS and 
Treasury do not believe that these results are appropriate because 
there is no evidence that the purchasing corporation's costs to acquire 
an amount of target stock sufficient for there to be a qualified stock 
purchase would increase proportionately if it acquired all of the 
target stock and the deemed asset sale mechanism allows taxpayers to 
avoid many of the costs that would be incurred in an actual asset sale. 
Accordingly, the IRS and Treasury have exercised the authority under 
section 338(b)(2) to prevent the grossing-up of selling costs and 
acquisitions costs.
Other Relevant Items
    The element other relevant items is removed from the definitions of 
both ADSP and AGUB as it no longer serves any function. In the current 
regulations, this element reduces ADSP for the purchasing corporation's 
acquisition

[[Page 43469]]

costs that would otherwise be taken into account because the 
purchaser's basis in recently purchased stock was an element in 
calculation of both ADSP and AGUB. This element becomes unnecessary 
with the removal of the link between ADSP and AGUB.

G. Section 1.338-6  Allocation of ADSP and AGUB Among Target Assets

Allocation of ADSP and AGUB Generally
    Apart from a change in the number of classes, the proposed 
regulations generally do not represent a substantive change in the 
system of allocation of ADSP and AGUB. The proposed regulation states 
the allocation rules that apply equally to ADSP and AGUB and then 
states the modifications to those common allocation rules for AGUB.
Transaction Costs
    Generally, the definition of fair market value is the price at 
which a willing seller will transfer an asset to a willing buyer. 
Therefore, the fair market value of a particular asset to a seller is 
not different from the fair market value of the same asset to a buyer, 
even though the economic value of the asset to each would reflect the 
selling costs or acquisition costs. A seller may reduce its amount 
realized on an asset and a buyer may increase its cost basis in an 
asset for the transaction costs specifically allocable to the asset in 
an actual asset sale. Because the underlying transaction in section 338 
is actually a stock sale, the costs incurred are not specifically 
allocable to any individual asset deemed transferred, but rather to the 
stock. Therefore, in applying the residual method to a deemed asset 
sale, transaction costs are accounted for only by decreasing the total 
amount realized by the seller or increasing the total cost basis of the 
buyer. In contrast, see the discussion of the treatment of transaction 
costs in an actual asset acquisition below.
IRS Challenges to Asset Fair Market Value
    Drawing from the existing rules under section 1060, the proposed 
regulations provide that the IRS may challenge a taxpayer's 
determination of the fair market value of any asset by any appropriate 
method and take into account all factors, including any lack of adverse 
tax interests between the parties.
Number and Content of Classes
    The seven classes under the proposed regulations are as follows: 
Class I, cash and cash equivalents; Class II, actively traded personal 
property as defined in section 1092(d), certificates of deposit, and 
foreign currency; Class III, accounts receivable, mortgages, and credit 
card receivables which arise in the ordinary course of business; Class 
IV, stock in trade of the taxpayer or other property of a kind which 
would properly be included in the inventory of taxpayer if on hand at 
the close of the taxable year, or property held by the taxpayer 
primarily for sale to customers in the ordinary course of his trade or 
business; Class V, all assets not in Class I, II, III, VI, or VII; 
Class VI, all section 197 intangibles except goodwill or going concern 
value; and Class VII, goodwill and going concern value.
AGUB Less Than the Amount of Class I Assets
    The proposed regulations clarify that, if the total AGUB (or 
consideration in an applicable asset acquisition under section 1060) to 
be allocated is less than the amount of Class I assets (i.e., cash and 
cash equivalents), then new target (or the purchaser in an applicable 
asset acquisition under section 1060) immediately recognizes ordinary 
income to that extent.
Marketable Securities
    The current regulations include marketable stock and securities, as 
defined in Sec. 1.351-1(c)(3), in Class II. Marketable stock and 
securities are included in Class II because a value can be easily 
assigned at any given time by looking at the value at which those 
instruments were trading on a securities exchange. Since the time Class 
II was first defined, financial markets have evolved and a greater 
variety of financial instruments can be readily valued in the same 
manner. The proposed regulations instead defines Class II with respect 
to actively traded personal property as defined under section 1092(d) 
because the regulations under that section have a more comprehensive 
definition of public financial markets.
Fast Pay Assets
    The IRS and Treasury are aware that many taxpayers engage in 
transactions solely to avoid the impairment problems with fast-pay 
assets. In addition, the IRS spends time evaluating whether such 
transactions are subject to challenge under the section 338 regulations 
or general principles of tax law. In order to address these concerns, 
the proposed regulations create two new classes of assets between 
current Classes II and III, one for accounts receivable, mortgages, and 
credit card receivables which arise in the ordinary course of business 
and another for stock in trade of the taxpayer or other property of a 
kind which would properly be included in the inventory of taxpayer if 
on hand at the close of the taxable year, or property held by the 
taxpayer primarily for sale to customers in the ordinary course of its 
trade or business.
Residual Class
    In the current regulations, Class V, the residual class, is 
comprised of section 197 intangibles in the nature of goodwill and 
going concern value. Class IV is comprised of all section 197 
intangibles except those in the nature of goodwill and going concern 
value. Because many section 197 intangibles would have been 
characterized by the IRS as assets in the nature of goodwill and going 
concern value prior to the enactment of section 197, the current 
regulations provide somewhat ambiguous guidance as to the line between 
current Class IV and current Class V. Accordingly, the proposed 
regulations remove the phrase ``in the nature of.'' Furthermore, in 
rare circumstances, goodwill or going concern value is not a section 
197 intangible. The residual class should include all goodwill and 
going concern value to ensure that the residual method serves the 
purpose of reducing valuation controversies. Therefore, the proposed 
regulations define the residual class as goodwill and going concern 
value without any reference to whether those assets would qualify as 
section 197 assets.
    In TD 8711, supra, the IRS amended the current regulations to adapt 
the residual method to section 197 by creating a new Class IV for 
section 197 intangibles other than goodwill or going concern value and 
providing that goodwill and going concern value would remain in a true 
residual class. The proposed regulations retain this distinction in 
renumbered Class VI and Class VII. Allocating goodwill and going 
concern value to Class VII avoids the need for determining the value of 
goodwill and going concern value through a non-residual method.
Allocation of AGUB When Gain Recognition Election Available but Not 
Made
    When the purchaser of the target stock holds nonrecently purchased 
target stock and no section 338(h)(10) election is made, the purchaser 
has the option of making or not making the gain recognition election. 
(If a section 338(h)(10) election is made, the making of the gain 
recognition election is automatic rather than elective.) The proposed 
regulations retain these rules. The current regulations have a special 
allocation rule when the failure to make

[[Page 43470]]

the gain recognition election leaves AGUB less than ADSP (that is, when 
the purchaser's nonrecently purchased stock was bought at a lower price 
than the recently purchased stock). Under the special allocation rule, 
AGUB, after reduction by the amount of Class I assets, is allocated 
among all other assets, regardless of their class, in proportion to 
their fair market values. (For this purpose, the fair market value of 
assets in the residual class (current Class V) is deemed to be the 
excess, if any, of the hypothetical purchase price over the sum of the 
Class I assets and the fair market values of the Class II, III, and IV 
assets. The hypothetical purchase price is the AGUB that would result 
if a gain recognition election were made.)
    If, looking at the hypothetical purchase price, full fair market 
value was paid on the acquisition date for assets in each class above 
the residual class, the current regulation's special allocation rule 
spreads the impairment that arises because no gain recognition election 
was made equally among all assets in classes below Class I. However, 
if, looking at the hypothetical purchase price, full fair market value 
was not paid on the acquisition date for assets in each class above the 
residual class, this rule spreads the impairment that arises because no 
gain recognition election was made as well as the impairment that 
arises from the bargain purchase equally among all assets in classes 
below Class I. In the latter case, the prioritization of classes under 
the residual method becomes irrelevant by the failure to make a gain 
recognition election. Prior to the enactment of section 197, the effect 
of the current regulations generally would have been to shift basis 
from depreciable or amortizable assets to nondepreciable, 
nonamortizable assets.
    The proposed regulations modify the special allocation rule to 
minimize this effect. Generally, under the modified special allocation 
rule, the portion of AGUB (after reduction by the amount of Class I 
assets) to be allocated to each Class II, III, IV, V, VI, and VII asset 
is determined by multiplying (a) the amount that would be allocated to 
such asset under the general rules for allocation of AGUB were AGUB 
increased to equal the hypothetical purchase price by (b) a fraction, 
the numerator of which is actual AGUB (after reduction by the amount of 
Class I assets) and the denominator of which is the hypothetical 
purchase price (after reduction by the amount of Class I assets). The 
reason for the modification is to spread only the impairment that 
arises because no gain recognition election was made equally among all 
assets in classes below Class I.
    The IRS and Treasury request comments as to whether any special 
allocation rule has continuing merit.

H. Section 1.338-7  Allocation of Redetermined ADSP and AGUB Among 
Target Assets

In General
    Section 1.338(b)-3T of the current regulations addresses subsequent 
adjustments to ADSP and AGUB. In the proposed regulations, these rules, 
contained in Sec. 1.338-7, have been streamlined and some of their 
content has been moved to the sections defining ADSP and AGUB, 
Secs. 1.338-4 and 1.338-5 respectively. The proposed regulations 
eliminate the use of the term adjustment event used in certain 
provisions of the current regulations. Instead, the proposed 
regulations provide simply that when general principles of tax law 
require a change in the amount of any of the various elements of ADSP 
or AGUB (discussed earlier), the new ADSP or AGUB amount is reapplied 
to produce new allocations to the assets. This generally is not 
intended as a substantive change to the current rules for subsequent 
adjustments provided in Sec. 1.338(b)-3T.
Item-Specific Adjustments
    The current regulations at Sec. 1.338(b)-3T contain special rules 
for changes to AGUB (and thus, indirectly, to ADSP) that relate to the 
income produced by intangible assets. The special rules apply for 
purposes of allocating an increase or decrease in AGUB or ADSP to the 
extent (a) the contingency that results in the increase or decrease 
directly relates to income produced by a particular intangible asset 
(contingent income asset) and (b) the increase or decrease is related 
to such contingent income asset and not to other target assets. The 
special rules consist of two provisions that vary from the normal rules 
of Sec. 1.338(b)-3T. Under the first provision, the fair market value 
of the contingent income asset at the beginning of the day after the 
acquisition date is redetermined at the time of the increase or 
decrease in AGUB or ADSP (but only those circumstances that resulted in 
the increase or decrease to AGUB or ADSP are taken into account in the 
redetermination). Under the second, the increase or decrease in AGUB or 
ADSP is allocated first to the contingent income asset, not to all 
assets generally under the normal allocation rules. Any portion that 
cannot be so allocated because of the fair market value limitation (as 
redetermined) is allocated under the normal allocation rules.
    The intent of this rule was to accommodate the uncertainties in the 
valuation of contingent income assets. The rule produces an allocation 
that would have resulted if the parties had known on the acquisition 
date the fair market value of the contingent income asset (as 
determined, with hindsight, on the date of the adjustment event) and 
paid on the acquisition date the increased or decreased consideration. 
The IRS and Treasury weighed the usefulness of this rule with its 
complexity and decided that the proposed regulations should not include 
any item-specific adjustment rule. Commentators, if they believe that 
the item-specific adjustment rule continues to serve a useful function 
that justifies its retention, should identify in their comments in what 
circumstances the rule has proven useful or could prove useful. 
Commentators should also identify what provisions would be necessary 
for an effective item-specific adjustment rule.

I. Section 1.338(h)(10)-1  Deemed Asset Sale and Liquidation

Model
    The proposed regulations explain the effects of the section 
338(h)(10) election on the parties involved. The proposed regulations 
discuss the effects of the section 338(h)(10) election on the 
purchasing corporation, the effects on new target, the effects on old 
target, and the effects on old target's shareholders (including non-
selling shareholders).
    As with the rest of the proposed regulations, proposed 
Sec. 1.338(h)(10)-1 describes the model on which taxation of the 
section 338(h)(10) election is based. Under the proposed regulations, 
old target is treated as transferring all of its assets by sale to an 
unrelated person. Old target recognizes the deemed sale gain while a 
member of the selling consolidated group, or owned by the selling 
affiliate, or owned by the S corporation shareholders (both those who 
actually sell their shares and any who do not). Old target is then 
treated as transferring all of its assets to members of the selling 
consolidated group, the selling affiliate, or S corporation 
shareholders and ceasing to exist. If target is an S corporation, the 
deemed asset sale and deemed liquidation are considered as occurring 
while it is still an S corporation. The proposed regulations treat all 
parties concerned as if the fictions the section 338(h)(10) regulations 
deem to occur actually did occur, or as closely thereto as possible. 
The structure of this model

[[Page 43471]]

should help taxpayers answer any questions not explicitly addressed by 
the proposed regulations. Also, old target generally is barred by the 
proposed regulations from obtaining any tax benefit from the section 
338(h)(10) election that it would not obtain if it actually sold its 
assets and liquidated.
    The treatment of S corporation targets which own one or more 
qualified subchapter S subsidiaries (as defined in section 1361(b)(3)) 
is also addressed, as is the treatment of tiered targets (i.e., the 
order of their deemed asset sales and deemed liquidations).
Deemed Liquidation
    The current regulations provide that, when a section 338(h)(10) 
election is made, old target is deemed to sell all of its assets and 
distribute the proceeds in complete liquidation. The term complete 
liquidation is generally considered to be a term of art in tax law. The 
proposed regulations instead provide that old target transferred all of 
its assets to members of the selling consolidated group, the selling 
affiliate, or S corporation shareholders and ceased to exist, making it 
clear that the transaction following the deemed asset sale does not 
automatically qualify as a distribution in complete liquidation under 
either section 331 or 332. This is meant to clarify any inference one 
might draw from previous regulations that section 332 treatment is 
automatic under section 338(h)(10) in the case of an affiliated or 
consolidated group. For example, if S owns all of the stock of T, T is 
insolvent because of its indebtedness to S, P acquires T from S in a 
qualified stock purchase, and, as a condition of the sale, S cancels 
the debt owed it by T, and P and S make a section 338(h)(10) election 
for target, T's deemed liquidation would not qualify under section 332 
because S would not be considered to receive anything in return for its 
stock in T. Rev. Rul. 68-602 (1968-2 C.B. 135).
Special S Corporation Issues
    The current regulations provide that, notwithstanding the purchase 
of 80 percent of the shares of an S corporation by a purchasing C 
corporation, the S corporation continues to be considered an S 
corporation for purposes of determining the tax effects of the section 
338(h)(10) election to old target and its S corporation shareholders. 
For example, old target reports to its shareholders under section 1366 
the tax effects of its deemed asset sale, and the shareholders adjust 
their stock basis pursuant to section 1367. The proposed regulations 
clarify that when the target itself is an S corporation immediately 
before the acquisition date, any direct and indirect subsidiaries of 
target with respect to which qualified subchapter S subsidiary 
elections are in effect are considered to remain qualified subchapter S 
subsidiaries for purposes of target's and its S corporation 
shareholders' reporting the effects of target's deemed sale of assets 
and deemed liquidation. No similar rule applies when a qualified 
subchapter S subsidiary, as opposed to the S corporation that is its 
owner, is the target corporation. The IRS and Treasury request comments 
as to whether it would be beneficial to make section 338(h)(10) 
elections available for acquisitions of qualified subchapter S 
subsidiaries and as to how the section 338(h)(10) regulations should be 
modified to accommodate the unique taxation of these entities.
    The proposed regulations clarify the effects of the section 
338(h)(10) election on both selling and non-selling S corporation 
shareholders. For example, the proposed regulations clarify that all S 
corporation shareholders, selling or not, must consent to the making of 
the section 338(h)(10) election, particularly because the non-selling 
shareholders have to include their proportionate share of the deemed 
sale gain under section 1366. Form 8023 will be corrected to reflect 
this requirement.
Availability of the Section 453 Installment Method
    When some or all of the target stock is purchased for an 
installment obligation and a section 338(h)(10) election is made, the 
proposed regulations make the section 453 installment method available 
to old target in its deemed asset sale, as long as the deemed asset 
sale would otherwise qualify for installment sale reporting. Solely for 
purposes of the application of section 453 and related provisions to 
the deemed asset sale and subsequent deemed corporate liquidation under 
section 338(h)(10), old target generally is considered to receive from 
new target in the deemed asset sale consideration consisting of the 
installment obligation given to old target shareholders in exchange for 
recently purchased stock, the assumption of, or taking subject to, old 
target liabilities, and cash. Thus, regardless of its actual character, 
any consideration conveyed by the purchaser to the selling shareholders 
other than installment obligations is considered to have been in cash, 
including for instance the purchaser's assumption of, or taking subject 
to, liabilities of the selling shareholders. In addition, the amount of 
any grossing-up under Sec. 1.338-4(d) of the proposed regulations is 
deemed to be in the form of cash. For purposes of section 453, new 
target is considered to be the obligor on the installment obligation 
the purchasing corporation actually issued. The provisions of sections 
453(h), 453B(d), and 453B(h) may then apply to old target and its 
shareholders with respect to the deemed liquidation of old target 
following the deemed asset sale. In the deemed liquidation, a selling 
shareholder who actually received an installment obligation in the 
stock sale is deemed to receive that installment obligation as part of 
the liquidating distribution; the other shareholders are deemed to 
receive none of the installment obligation.
    The proposed regulations provide that old target generally is 
barred from obtaining any tax benefit from the section 338(h)(10) 
election that it would not obtain if it actually sold its assets and 
liquidated. This bar extends to the application of section 453. In 
other words, the results of application of section 453 to old target 
should be as close as possible to those that would occur if old target 
actually sold its assets for an installment obligation of the 
purchaser. Thus, for example, the installment method of section 453 
applies unless old target affirmatively elects out of the installment 
method.
    As another example, Sec. 15A.453-1(b)(2)(iv) provides that any 
obligation created subsequent to the taxpayer's acquisition of the 
property and incurred or assumed by the taxpayer or placed as an 
encumbrance on the property in contemplation of disposition of the 
property is not qualifying indebtedness if the arrangement results in 
accelerating recovery of the taxpayer's basis in the installment sale. 
Old target would be subject to this test with respect to its debts new 
target is deemed to assume or take subject to.
    Further, the rule of section 453A requiring payment of interest 
will apply in the same manner as it would apply if target actually sold 
all its assets in return for consideration that included an installment 
obligation from the purchaser and then distributed in complete 
liquidation all the consideration received.
Tiered Targets
    The proposed regulations provide that, in the case of parent-
subsidiary chains of corporations making section 338(h)(10) elections, 
the deemed asset sale at the parent level is considered to precede that 
at the subsidiary level. The proposed regulations then provide, 
however, that the deemed liquidation of

[[Page 43472]]

the subsidiary is considered to precede the deemed liquidation of the 
parent.
Additional Information Required
    The proposed regulations provide that the Commissioner may exercise 
the authority granted in section 338(h)(10)(C)(iii) to require the 
provision of any information deemed necessary to carry out the 
provisions of section 338(h)(10) by requiring submission of information 
on any tax reporting form. The IRS and Treasury are considering 
requiring that the information about the amount and allocation of AGUB 
and ADSP currently submitted on the election form (Form 8023) instead 
be submitted by the purchaser and seller(s) separately on their income 
tax returns, and is interested in comments on this approach.

J. Section 1.1060-1

Definition of Trade or Business
    Section 1060 applies to the direct or indirect transfer of a trade 
or business. Under the current regulations, a group of assets 
constitutes a trade or business if the use of such assets would 
constitute an active trade or business for purposes of section 355. 
Further, even if a group of assets would not qualify as an active trade 
or business for purposes of section 355, a group of assets will 
constitute a trade or business for purposes of section 1060 if goodwill 
or going concern value could attach under any circumstances. The 
current regulations set out factors that will be considered in 
determining whether goodwill or going concern could attach.
    Although the current regulations set out factors, there are still 
ambiguities regarding when goodwill or going concern value could 
attach. For example, Sec. 1.1060-1T(b)(2) has been misinterpreted to 
mean that a trade or business exists only when basis is allocated to 
goodwill or going concern value under the residual method. Under the 
misinterpretation, a taxpayer would be required to filter every bulk 
asset purchase through the residual allocation method in order to 
determine whether the transaction is subject to section 1060. The 
proposed regulations clarify that a trade or business is present if 
goodwill or going concern value could attach to the group of assets, 
regardless of whether any value will eventually be allocated to the 
residual class (Class VII).
    In addition, the proposed regulations provide that the presence of 
assets in the nature of section 197 assets is a factor to be considered 
in determining whether goodwill or going concern value could attach. 
This clarification recognizes that many section 197 assets would have 
been considered part of goodwill or going concern value at the time 
Congress enacted section 1060. However, the proposed regulations make 
it clear that the transfer of an isolated section 197 asset will not be 
subject to section 1060.
    The proposed regulations clarify that an applicable asset 
acquisition can occur even if the trade or business is transferred from 
seller to purchaser in a series of related transactions and that the 
residual method must be applied once to all of the assets transferred 
in a series of related transactions. The proposed regulations also 
incorporate the principles of the anti-abuse rule from Sec. 1.338-1(c) 
of the proposed regulations to determine which assets must be included 
for purposes of applying the residual method.
Asymmetrical Transfers of Assets
    Section 1060 applies to the direct or indirect acquisition of a 
trade or business when the purchaser's basis in the assets (other than 
assets to which section 1031 applies) is determined wholly by reference 
to the consideration paid by the purchaser. This rule clarifies that a 
purchaser of assets in an applicable asset acquisition is subject to 
the allocation rules set out in Secs. 1.338-6 and 1.338-7 even if the 
transferor in the transaction is treated as transferring something 
different from the assets the transferee is treated as receiving. For 
example, Rev. Rul. 99-6 (1999-6 I.R.B. 6) concerns the purchase, by one 
person, of all of the interests in a limited liability company which is 
classified as a partnership under Sec. 301.7701-3. The revenue ruling 
sets forth two situations and holds that each seller is treated as 
having transferred its interests in the partnership, while each 
purchaser is treated as having purchased the assets of the limited 
liability company. The proposed regulations make it clear that each 
purchaser described in Rev. Rul. 99-6 must use the residual method 
prescribed under Secs. 1.338-6 and 1.338-7 to allocate the 
consideration paid for the purchased assets (provided that the asset 
transfer otherwise qualifies as an applicable asset acquisition).
Multiple Trades or Businesses Transferred in a Single Transaction
    The current regulations are silent on the proper application of the 
residual method to situations when a seller transfers a group of assets 
that could be categorized as constituting more than one trade or 
business. The proposed regulations clarify that, as long as any part of 
the assets are a trade or business, all of the assets are to be treated 
as a single trade or business for purposes of applying the residual 
method. Therefore, the residual method should be applied once to all of 
the assets transferred, rather than to blocks of the assets separately. 
This rule is intended to reduce valuation conflicts regarding how much 
consideration should be allocated to each separate group of assets. By 
treating all of the assets as a single trade or business, all assets in 
Classes I through VI can receive full fair market value allocation 
before the goodwill of any trade or business is allocated basis. In 
addition, this rule brings actual asset acquisitions into conformity 
with deemed asset acquisitions by allocating consideration paid across 
all assets acquired, without looking to the trade or business with 
which they are associated.
Miscellaneous Changes
    The proposed regulations incorporate two miscellaneous changes 
addressing issues that have arisen under the current regulations. 
First, the proposed regulations include any covenants entered into 
between the seller and the purchaser in connection with an applicable 
asset acquisition as an asset transferred as part of a trade or 
business even though, to the seller, the covenant is a contract for 
services. As a result, sellers must include any covenants in the asset 
pool for purposes of applying the residual method, thus allowing for 
greater symmetry to be achieved between the purchaser and seller.
    Second, the like-kind exchange rule in the current regulation has 
been expanded. Under this expanded rule, if an applicable asset 
acquisition includes property that is transferred subject to any 
provision of the Code or regulations that has the tax effect of section 
1031, the tax treatment determined under such provision is given 
effect. The residual method is then applied to the remaining assets and 
consideration exchanged.
    In addition, the proposed regulations no longer separately state 
the residual allocation method. Instead, proposed Sec. 1.1060-1 
incorporates the residual method by cross reference to proposed 
regulations Secs. 1.338-6 and 1.338-7. Proposed regulation Sec. 1.1060-
1 only sets out rules in which the treatment of an actual asset 
acquisition differs from the treatment of a deemed asset acquisition. 
By cross-referencing the section 338 regulations rather than separately 
stating the residual method, the proposed regulations ensure that 
deemed and actual asset acquisitions will be treated similarly to the 
extent possible.

[[Page 43473]]

Transaction Costs
    Under the current regulations, consideration is allocated to each 
asset to the extent of that asset's fair market value as long as there 
is sufficient consideration to provide full allocation of basis to each 
asset in the class. The fair market value limitation and the residual 
allocation method of the current regulations do not permit costs 
associated with specific assets to be allocated to those assets. For 
example, if a purchaser incurred costs to acquire an asset and section 
1060 did not apply to the acquisition, the basis of that asset would be 
increased to reflect those costs. However, the fair market value 
limitation under the current regulations would limit a purchaser's 
basis in the asset to its fair market value. The proposed regulations 
allow the buyer and seller to adjust their allocation of consideration 
to particular assets for costs incurred which are specifically 
identified with those assets. Thus, the total amount the seller 
allocates to an asset for which it incurs specifically identifiable 
costs would be less than its fair market value and, for the buyer, 
greater than its fair market value. The parties are not allowed to 
apportion costs associated generally with the overall transaction to 
specific assets. A similar rule is not necessary, and therefore not 
included, under section 338, because the underlying transaction is a 
stock sale. Any costs associated with a deemed asset sale are of the 
type generally associated with the overall sale of stock and, 
therefore, the parties would not be allowed to apportion those costs to 
specific assets under the rule.
Written Allocation Agreements
    After the current regulations were adopted, Congress amended 
section 1060 to provide that a written agreement allocating purchase 
price is binding on both parties. See section 1060(a). The legislative 
history indicates that parties must report consistent with their 
agreed-upon allocations, unless the parties are able to refute the 
agreement under the standards set forth in Commissioner v. Danielson, 
378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967). The proposed 
regulations incorporate the Danielson standard by reference.

Specific Requests for Comments and Matters Under Study

A. Examples in the Section 338 and Section 1060 Regulations

    The proposed regulations, for the most part, retain the examples of 
the current regulations. The retained examples are updated to reflect 
the changes in the location, terminology, and substance of the 
regulations which they illustrate. Some examples have been dropped as 
it was thought that they were unnecessary. Comments are requested as to 
whether any of the retained examples (or new examples) are superfluous 
and whether other examples are necessary to illustrate the regulations.

B. Discharge of Indebtedness Income in the Case of Tiered Targets Under 
Section 338 and the Current Regulations

    Taxpayers may inadvertently experience adverse tax consequences 
when there is intercompany indebtedness owing between tiered targets 
acquired in the same qualified stock purchase. Such consequences might 
include the realization of discharge of indebtedness income and changes 
to the issue price of the indebtedness. The latter could affect the 
total amount of AGUB to be allocated.
    For example, assume that T owns 100 percent of the stock of T1, T 
and T1 do not file a consolidated return, and T is indebted to T1. 
Assume also that P acquires all the stock of T in a qualified stock 
purchase and makes section 338 elections for both T and T1. Under 
Sec. 1.338-2(b)(4), first old T is considered to sell its assets to new 
T, and new T is deemed to assume the debt of old T to old T1. Next, old 
T1 is deemed to sell its assets to new T1. New T1 thus may be 
considered to acquire debt owed by new T (to old T1) at a time when new 
T1 is related to new T.
    Under section 108(e)(4), this may trigger discharge of indebtedness 
income for new T if new T1's adjusted basis in the acquired debt is 
less than the amount of the debt (see Sec. 1.108-2(f)(1)). That might 
occur when the T stock is purchased partly for contingent consideration 
not originally taken into account in AGUB. A variety of similar issues 
may arise under Sec. 1.1502 13(g).
    The IRS and Treasury solicit comments on whether the application of 
section 108(e)(4) and Sec. 1.1502-13(g) is appropriate in these 
circumstances and how one might best address these consequences.

C. Ideas for Revision of Application of the Residual Method of 
Allocation Under Section 338 in the Case of Tiered Targets

In General
    The IRS and Treasury are studying ways of addressing the allocation 
of ADSP and AGUB in the case of tiered targets making section 338 
elections. Set forth below is the framework for one potential method 
that would equalize the amount of impairment for assets in a given 
class without regard to which target corporation owns the assets. This 
method uses a lookthrough approach. The method is incomplete, raises 
difficult issues, and is more complicated than the current rules. For 
these reasons, the proposed regulations do not adopt the method. 
However, the IRS and Treasury request comments as to the value and 
feasibility of the method; how best to resolve its issues; and what 
alternative approaches might be better. For instance, would it be 
better to have a complicated special method such as that described 
below that operates in every case of tiered targets or, as the proposed 
regulations do, retain the approach of the current regulations with the 
addition of an anti-abuse rule, the goal of which is to restrict 
movement of assets in advance of the qualified stock purchase 
undertaken to benefit from the shortcomings of the current top-down 
rules?
    Essentially, the lookthrough approach referred to above would 
revise the treatment of Classes I through V (referring to the class 
numbering system of the proposed regulations). In allocating to these 
senior classes, the tiered targets would be aggregated for purposes of 
calculating the overall purchase price and allocating that amount among 
the individual assets. This rule would apply to a target (referred to 
as the parent target) and to those of its lower tier subsidiaries for 
which a section 338 election is also made (referred to as subsidiary 
targets). Stock in subsidiaries for which section 338 elections are not 
or cannot be made would continue to be treated for all purposes as a 
Class V asset (or Class II if publicly traded)--in other words, such 
entities would not participate in the aggregation.
    The method would thereafter switch back to the normal top-down 
system for allocation to assets in Classes VI and VII, because the 
process of dividing up the amount allocated to the aggregate goodwill 
of all the targets under the residual method would be antithetical to 
the notion that goodwill is best valued by looking at what value is 
left over rather than being separately valued, and because both Class 
VI and VII assets generally get the same 15 year amortization period 
pursuant to section 197-hence determining which of those two classes or 
assets within the classes receives a given dollar of basis is 
relatively insignificant.
    An issue in applying the method is how to treat liabilities owed by 
one group member to another. The IRS and Treasury request comments as 
to whether such liabilities should be

[[Page 43474]]

treated for all allocation purposes as not debt but as stock in the 
debtor-member held by the creditor-member, and whether to do so even if 
the creditor-member is a subsidiary of the debtor-member.
    One possible method of implementing the method is set forth in 
greater detail, below. Possible method of implementation of the 
lookthrough approach
    The first step under the method would be to calculate the total 
amount to be allocated (ADSP and AGUB). Under the method, this would be 
the sum of (a) the amount realized or basis, as appropriate, of the 
parent target stock (grossed-up as appropriate to reflect stock not 
recently purchased, etc.) and (b) liabilities.
    In the second step, all Class I through Class V assets in the 
parent target and subsidiary targets (other than stock of subsidiary 
targets) would be combined into aggregate Classes I, II, III, IV, and 
V. Then, the total basis would be allocated (as basis is under the 
current system, except that the allocation would be across such joint 
classes, not merely within individual members) first to Class I assets, 
then, if there is any remainder, to Class II assets, then, if there is 
any remainder, to Class III assets, then, if there is any remainder, to 
Class IV assets, and then, if there is any remainder, to Class V 
assets. The allocations thus made to individual Class I through V 
assets would be the final, binding allocations to them.
    In the third step, if there were no amount of the total basis 
remaining to be allocated to Class VI and VII assets, one would proceed 
to determine the basis in subsidiary target stock. If the aggregate 
amount assigned to all the subsidiary's Class I through V assets 
pursuant to the second step above exceeded the amount of the 
subsidiary's liabilities, then the amount of the excess would become 
its parent's basis in that subsidiary's stock.
    If the aggregate amount were, however, less than the liabilities, 
then the stock basis would be zero. A subissue is whether in such case 
other action should also be taken: whether, in the case of a 
consolidated group, an excess loss account should be created equal to 
the amount of the shortfall; and whether, if the tiered entities do not 
join in filing a consolidated return but other nonconsolidated 
investment adjustment rules apply, future positive basis increases 
should be denied to the extent of the excess loss account that would 
have been created under the method had they been filing consolidated. 
The rule could apply, for example, to increases in basis of controlled 
foreign corporations for undistributed earnings taxed currently under 
subpart F.
    Under the method, if there were an amount of the total ADSP or AGUB 
remaining to be allocated to Class VI and VII assets, then one would 
proceed to allocate basis to Class VI and VII assets. At this point, 
the aggregating of members' assets into joint classes would be 
abandoned and the method would revert to a top-down system similar to 
that of current rules. The process is top-down in that any basis not 
already allocated to the parent target's Class I through V assets 
(other than subsidiary target stock) would be allocated among its Class 
VI and VII assets and subsidiary target stock, then the subsidiary 
target would in turn make its own allocation of its own basis among its 
own Class VI and VII assets and any stock it might own in other 
subsidiary targets.
    Certain adjustments, as yet undetermined, would have to be made to 
this method for minority interests outstanding in subsidiaries.
Possible Disadvantages of the Method
    The method has drawbacks:
    (1) Complexity. The method is more complicated than the existing 
rules. When, for example, there is a subsequent change in the amount of 
a liability of a subsidiary target that changes the amount of AGUB or 
ADSP, under the method one would recalculate the allocations to all the 
assets of the parent target and all subsidiary targets, not just the 
assets of the indebted subsidiary target and its own subsidiary 
targets.
    Also, questions arise regarding subsequent changes in AGUB and 
ADSP, with respect to subsidiary targets already disposed of. What if, 
for instance, at the time of a subsequent adjustment to AGUB or ADSP, 
the group had already disposed of the stock of a particular subsidiary 
target should one change the allocation to that former subsidiary's 
assets? Separately, in determining whether AGUB or ADSP has changed, 
should one take into account changes in the amount of liabilities of 
former subsidiary targets? How would the group be made aware of such 
changes?
    (2) Lack of inside-outside basis conformity. The current system, 
although it tolerates large disparities in the allocations to identical 
assets based on location, assures conformity between stock basis and 
net asset basis. The look-through approach does so only in a 
consolidated setting (employing excess loss accounts to do so).
    (3) The method would not eliminate all allocation disparities. The 
method would not completely eliminate disparate allocations based on 
location within the acquired group, because it applies only to tiered 
targets. Similar disparities can exist in acquisitions of sister 
corporations or in mixed stock and asset purchases. The method does not 
include a mechanism for equalizing basis impairment in such cases. 
Thus, the method would not fully solve the disparity problem. (Note, 
however, that the new anti-abuse rule included in the proposed 
regulations may operate in some cases.)

Proposed Effective Date

    The regulations are proposed to be effective on the date that final 
regulations are published in the Federal Register and apply to 
qualified stock purchases or applicable asset acquisitions occurring on 
or after the date that final regulations are published in the Federal 
Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. An initial 
regulatory flexibility analysis has been prepared pursuant to 5 U.S.C. 
section 604 for the collections of information in this Treasury 
Decision. The analysis is set forth below under the heading ``Initial 
Regulatory Flexibility Analysis.'' Pursuant to section 7805(f) of the 
Code, these regulations will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

Initial Regulatory Flexibility Analysis

    This regulatory action is intended to simplify and clarify the 
current rules relating to both deemed and actual asset acquisitions. 
The current rules were developed over a long period of time and have 
been repeatedly amended. The IRS and Treasury believe these proposed 
regulations will significantly improve the clarity of the rules 
relating to both deemed and actual asset acquisitions.
    The major objective of the proposed regulations is to modify the 
rules for allocating purchase price in both deemed and actual asset 
acquisitions. In addition, the proposed regulations replace the general 
rules for electing to treat a stock sale as an asset sale.
    These collections of information may affect small businesses if the 
stock of a corporation which is a small entity is acquired in a 
qualified stock purchase or if a trade or business which is also a 
small business is transferred in a

[[Page 43475]]

taxable transaction. Form 8023 (on which an election to treat a stock 
sale as an asset sale is filed) has been submitted to and approved by 
the Office of Management and Budget. With respect to Form 8023, the IRS 
estimated that 201 forms would be filed each year and that each 
taxpayer would require 12.98 hours to comply. Form 8594 (on which a 
sale or acquisition of assets constituting a trade or business is 
reported) has also been submitted to and approved by the Office of 
Management and Budget. With respect to Form 8594, the IRS estimated 
that 20,000 forms would be filed each year and that each taxpayer would 
require 12.25 hours to comply. These estimates have been made available 
for public comment and no public comments have been received. These 
proposed regulations do not impose new requirements on small businesses 
and, in fact, should lessen any difficulties associated with the 
existing reporting requirements by clarifying the rules associated with 
deemed and actual asset acquisitions.
    The collections of information require taxpayers to file an 
election in order to treat a stock sale as an asset sale. In addition, 
taxpayers must file a statement regarding the amount of consideration 
allocated to each class of assets under the residual method. The 
professional skills that would be necessary to make the election or 
allocate the consideration would be the same as those required to 
prepare a return for the small business.
    Consideration was given to limiting the reporting requirements 
under section 1060 to trades or businesses meeting a threshold level of 
business activity. However, any threshold derived without further 
information would be arbitrary. Instead, the proposed regulations 
authorize the Commissioner to exclude certain transactions from the 
reporting requirements.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are timely submitted to the IRS. The IRS and 
Treasury request comments on the clarity of the proposed rule and how 
it may be made easier to understand. All comments will be available for 
public inspection and copying.
    A public hearing has been scheduled for October 12, 1999, beginning 
at 10 a.m. in the NYU Classroom, Room 2615, Internal Revenue Service 
Building, 1111 Constitution Avenue, NW., Washington, DC. Due to 
building security procedures, visitors must enter at the 10th Street 
entrance, located between Constitution and Pennsylvania Avenues, NW. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 15 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The IRS recognizes that persons outside the Washington, DC, area 
may also wish to testify at the public hearing through 
teleconferencing. Requests to include teleconferencing sites must be 
received by September 20, 1999. If the IRS receives sufficient 
indications of interest to warrant teleconferencing to a particular 
city, and if the IRS has teleconferencing facilities available in that 
city on the date the public hearing is to be scheduled, the IRS will 
try to accommodate the requests. The IRS will publish the locations of 
any teleconferencing sites in an announcement in the Federal Register.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must request to speak, and 
submit written comments and an outline of the topics to be discussed 
and the time to be devoted to each topic (a signed original and eight 
(8) copies) by September 20, 1999. A period of ten minutes will be 
allocated to each person for making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.
    Drafting information. The principal authors of these proposed 
regulations are Richard Starke and Stephen R. Wegener, Office of the 
Assistant Chief Counsel (Corporate). However, other personnel from the 
IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entries for 1.338(b)-1, 1.338(b)-3T, and 1.1060 1T and by 
adding entries in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.338-6 also issued under 26 U.S.C. 337(d), 338, and 
1502.
    Section 1.338-7 also issued under 26 U.S.C. 337(d), 338, and 
1502.
    Section 1.338-8 also issued under 26 U.S.C. 337(d), 338, and 
1502.
    Section 1.338-9 also issued under 26 U.S.C. 337(d), 338, and 
1502.
    Section 1.338-10 also issued under 26 U.S.C. 337(d), 338, and 
1502.* * *
    Section 1.1060-1 also issued under 26 U.S.C. 1060.* * *

    Par. 2. Sections 1.338-0 through 1.338-3 are revised to read as 
follows:


Sec. 1.338-0  Outline of topics.

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

Sec. 1.338-1  General principles; status of old target and new 
target.
    (a) In general.
    (1) Deemed transaction.
    (2) Application of other rules of law.
    (3) Overview.
    (b) Treatment of target under other provisions of the Internal 
Revenue Code.
    (1) General rule for subtitle A.
    (2) Exceptions for subtitle A.
    (3) General rule for other provisions of the Internal Revenue 
Code.
    (c) Anti-abuse rule.
    (1) In general.
    (2) Examples.
Sec. 1.338-2  Nomenclature and definitions; mechanics of the section 
338 election.
    (a) Scope.
    (b) Nomenclature.
    (c) Definitions.
    (1) Acquisition date.
    (2) Acquisition date assets.
    (3) Affiliated group.
    (4) Common parent.
    (5) Consistency period.
    (6) Deemed asset sale.
    (7) Deemed sale gain.
    (8) Deemed sale return.
    (9) Domestic corporation.
    (10) Old target's final return.
    (11) Purchasing corporation.
    (12) Qualified stock purchase.
    (13) Related persons.
    (14) Section 338 election.
    (15) Section 338(h)(10) election.
    (16) Selling group.
    (17) Target; old target; new target.
    (18) Target affiliate.
    (19) 12-month acquisition period.
    (d) Time and manner of making election.
    (e) Special rules for foreign corporations or DISCs.
    (1) Elections by certain foreign purchasing corporations.
    (i) General rule.

[[Page 43476]]

    (ii) Qualifying foreign purchasing corporation.
    (iii) Qualifying foreign target.
    (iv) Triggering event.
    (v) Subject to United States tax.
    (2) Acquisition period.
    (3) Statement of section 338 may be filed by United States 
shareholders in certain cases.
    (4) Notice requirement for U.S. persons holding stock in foreign 
market.
    (i) General rule.
    (ii) Limitation.
    (iii) Form of notice.
    (iv) Timing of notice.
    (v) Consequence of failure to comply.
    (vi) Good faith effort to comply.
Sec. 1.338-3  Qualification for the section 338 election.
    (a) Scope.
    (b) Rules relating to qualified stock purchases.
    (1) Purchasing corporation requirement.
    (2) Purchase.
    (i) Definition.
    (ii) Purchase of target.
    (iii) Purchase of target affiliate.
    (3) Acquisitions of stock from related corporations.
    (i) In general.
    (ii) Time for testing relationship.
    (iii) Cases where section 338(h)(3)(C) applies--acquisitions 
treated as purchases.
    (iv) Examples.
    (4) Acquisition date for tiered targets.
    (i) Stock sold in deemed asset sale.
    (ii) Examples.
    (5) Effect of redemptions.
    (i) General rule.
    (ii) Redemptions from persons unrelated to the purchasing 
corporation.
    (iii) Redemptions from the purchasing corporation or related 
persons during 12-month acquisition period.
    (A) General rule.
    (B) Exception for certain redemptions from related corporations.
    (iv) Examples.
    (c) Effect of post-acquisition events on eligibility for section 
338 election.
    (1) Post-acquisition elimination of target.
    (2) Post-acquisition elimination of the purchasing corporation.
    (3) Consequences of post-acquisition elimination of target.
    (i) Scope.
    (ii) Continuity of interest.
    (iii) Control requirement.
    (iv) Example.
Sec. 1.338-4  Aggregate deemed sale price; various aspects of 
taxation of the deemed asset sale.
    (a) Scope.
    (b) Determination of ADSP.
    (1) General rule.
    (2) Time and amount of ADSP.
    (i) Original determination.
    (ii) Redetermination of ADSP.
    (iii) Example.
    (c) Grossed-up amount realized on the sale to the purchasing 
corporation of the purchasing corporation's recently purchased 
target stock.
    (1) Determination of amount.
    (2) Example.
    (d) Liabilities of old target.
    (1) In general.
    (2) Time and amount of liabilities.
    (3) Interaction with deemed sale gain.
    (e) Calculation of deemed sale gain.
    (f) Other rules apply in determining ADSP.
    (g) Examples.
    (h) Deemed sale of target affiliate stock.
    (1) Scope.
    (2) In general.
    (3) Deemed sale of foreign target affiliate by a domestic 
target.
    (4) Deemed sale producing effectively connected income.
    (5) Deemed sale of insurance company target affiliate electing 
under section 953(d).
    (6) Deemed sale of DISC target affiliate.
    (7) Anti-stuffing rule.
    (8) Examples.
Sec. 1.338-5  Adjusted grossed-up basis.
    (a) Scope.
    (b) Determination of AGUB.
    (1) General rule.
    (2) Time and amount of AGUB.
    (i) Original determination.
    (ii) Redetermination of AGUB.
    (iii) Examples.
    (c) Grossed-up basis of recently purchased stock.
    (d) Basis of nonrecently purchased stock; gain recognition 
election.
    (1) No gain recognition election.
    (2) Procedure for making gain recognition election.
    (3) Effect of gain recognition election.
    (i) In general.
    (ii) Basis amount.
    (iii) Losses not recognized.
    (iv) Stock subject to election.
    (e) Liabilities of new target.
    (1) In general.
    (2) Time and amount of liabilities.
    (3) Interaction with deemed sale gain.
    (f) Adjustments by the Internal Revenue Service.
    (g) Examples.
Sec. 1.338-6  Allocation of ADSP and AGUB among target assets.
    (a) Scope.
    (1) In general.
    (2) Fair market value.
    (i) In general.
    (ii) Transaction costs.
    (iii) Internal Revenue Service authority.
    (b) General rule for allocating ADSP and AGUB.
    (1) Reduction in the amount of consideration for Class I assets.
    (2) Other assets.
    (i) In general.
    (ii) Class II assets.
    (iii) Class III assets.
    (iv) Class IV assets.
    (v) Class V assets.
    (vi) Class VI assets.
    (vii) Class VII assets.
    (3) Other items designated by the Internal Revenue Service.
    (c) Certain limitations and other rules for allocation to an 
asset.
    (1) Allocation not to exceed fair market value.
    (2) Allocation subject to other rules.
    (3) Special rule for allocating AGUB when purchasing corporation 
has nonrecently purchased stock.
    (i) Scope.
    (ii) Determination of hypothetical purchase price.
    (iii) Allocation of AGUB.
    (4) Liabilities taken into account in determining amount 
realized on subsequent disposition.
    (d) Examples.
Sec. 1.338-7  Allocation of redetermined ADSP and AGUB among target 
assets.
    (a) Scope.
    (b) Allocation of redetermined ADSP and AGUB.
    (c) Special rules for ADSP.
    (1) Increases or decreases in deemed sale gain taxable 
notwithstanding old target ceases to exist.
    (2) Procedure for transactions in which section 338(h)(10) is 
not elected.
    (i) Deemed sale gain included in new target's return.
    (ii) Carryovers and carrybacks.
    (A) Loss carryovers to new target taxable years.
    (B) Loss carrybacks to taxable years of old target.
    (C) Credit carryovers and carrybacks.
    (3) Procedure for transactions in which section 338(h)(10) is 
elected.
    (d) Special rules for AGUB.
    (1) Effect of disposition or depreciation of acquisition date 
assets.
    (2) Section 38 property.
    (e) Examples.
Sec. 1.338-8  Asset and stock consistency.
    (a) Introduction.
    (1) Overview.
    (2) General application.
    (3) Extension of the general rules.
    (4) Application where certain dividends are paid.
    (5) Application to foreign target affiliates.
    (6) Stock consistency.
    (b) Consistency for direct acquisitions.
    (1) General rule.
(2) Section 338(h)(10) elections.
(c) Gain from disposition reflected in basis of target stock.
(1) General rule.
(2) Gain not reflected if section 338 election made for target.
(3) Gain reflected by reason of distributions.
(4) Controlled foreign corporations.
(5) Gain recognized outside the consolidated group.
(d) Basis of acquired assets.
(1) Carryover basis rule.
(2) Exceptions to carryover basis rule for certain assets.
(3) Exception to carryover basis rule for de minimis assets.
(4) Mitigation rule.
(i) General rule.
(ii) Time for transfer.
(e) Examples.
(1) In general.
(2) Direct acquisitions.
(f) Extension of consistency to indirect acquisitions.
(1) Introduction.
(2) General rule.
(3) Basis of acquired assets.
(4) Examples.
(g) Extension of consistency if dividends qualifying for 100 percent 
dividends received deduction are paid.

[[Page 43477]]

(1) General rule for direct acquisitions from target.
(2) Other direct acquisitions having same effect.
(3) Indirect acquisitions.
(4) Examples.
(h) Consistency for target affiliates that are controlled foreign 
corporations.
(1) In general.
(2) Income or gain resulting from asset dispositions.
(i) General rule.
(ii) Basis of controlled foreign corporation stock.
(iii) Operating rule.
(iv) Increase in asset or stock basis.
(3) Stock issued by target affiliate that is a controlled foreign 
corporation.
(4) Certain distributions.
(i) General rule.
(ii) Basis of controlled foreign corporation stock.
(iii) Increase in asset or stock basis.
(5) Examples.
(i) [Reserved]
(j) Anti-avoidance rules.
(1) Extension of consistency rules.
(2) Qualified stock purchase and 12-month acquisition period.
(3) Acquisitions by conduits.
(i) Asset ownership.
(A) General rule.
(B) Application of carryover basis rule.
(ii) Stock acquisitions.
(A) Purchase by conduit.
(B) Purchase of conduit by corporation.
(C) Purchase of conduit by conduit.
(4) Conduit.
(5) Existence of arrangement.
(6) Predecessor and successor.
(i) Persons.
(ii) Assets.
(7) Examples.
Sec. 1.338-9  International Aspects of Section 338.
(a) Scope.
(b) Application of section 338 to foreign targets.
(1) In general.
(2) Ownership of FT stock on the acquisition date.
(3) Carryover FT stock.
(i) Definition.
(ii) Carryover of earnings and profits.
(iii) Cap on carryover of earnings and profits.
(iv) Post-acquisition date distribution of old FT earnings and 
profits.
(v) Old FT earnings and profits unaffected by post-acquisition date 
deficits.
(vi) Character of FT stock as carryover FT stock eliminated upon 
disposition.
(4) Passive foreign investment company stock.
(c) Dividend treatment under section 1248(e).
(d) Allocation of foreign taxes.
(e) Operation of section 338(h)(16). [Reserved]
(f) Examples.
Sec. 1.338-10  Filing of Returns.
(a) Returns including tax liability from deemed asset sale.
(1) In general.
(2) Old target's final taxable year otherwise included in 
consolidated return of selling group.
(i) General rule.
(ii) Separate taxable year.
(iii) Carryover and carryback of tax attributes.
(iv) Old target is a component member of purchasing corporation's 
controlled group.
(3) Old target is an S corporation.
(4) Combined deemed sale return.
(i) General rule.
(ii) Gain and loss offsets.
(iii) Procedure for filing a combined return.
(iv) Consequences of filing a combined return.
(5) Deemed sale excluded from purchasing corporation's consolidated 
return.
(6) Due date for old target's final return.
(i) General rule.
(ii) Application of Sec. 1.1502 76(c).
(A) In general.
(B) Deemed extension.
(C) Erroneous filing of deemed sale return.
(D) Erroneous filing of return for regular tax year.
(E) Last date for payment of tax.
(7) Examples.
(b) Waiver.
(1) Certain additions to tax.
(2) Notification.
(3) Elections or other actions required to be specified on a timely 
filed return.
(i) In general.
(ii) New target in purchasing corporation's consolidated return.
(4) Examples.
Sec. 1.338(h)(10)-1  Deemed Asset Sale and Liquidation.
(a) Scope.
(b) Definitions.
(1) Consolidated target.
(2) Selling consolidated group.
(3) Selling affiliate; affiliated target.
(4) S corporation target.
(5) S corporation shareholders.
(6) Liquidation.
(c) Section 338(h)(10) election.
(1) In general.
(2) Simultaneous joint election requirement.
(3) Irrevocability.
(4) Effect of invalid election.
(d) Certain consequences of section 338(h)(10) election.
(1) P.
(2) New T.
(3) Old T--deemed sale.
(i) In general.
(ii) Tiered targets.
(4) Old T and selling consolidated group, selling affiliate, or S 
corporation shareholders--deemed liquidation; tax characterization.
(i) In general.
(ii) Tiered targets.
(5) Selling consolidated group, selling affiliate, or S corporation 
shareholders.
(i) In general.
(ii) Basis and holding period of T stock not acquired.
(iii) T stock sale.
(6) Nonselling minority shareholders other than nonselling S 
corporation shareholders.
(i) In general.
(ii) T stock sale.
(iii) T stock not acquired.
(7) Consolidated return of selling consolidated group.
(8) Availability of the section 453 installment method.
(i) In deemed asset sale.
(ii) In deemed liquidation.
(9) Treatment consistent with an actual asset sale.
(e) Examples.
(f) Inapplicability of provisions.
(g) Required information.
Sec. 1.338(i)-1  Effective dates.


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

    (a) In general--(1) Deemed transaction. Elections are available 
under section 338 when a purchasing corporation acquires the stock of 
another corporation (the target) in a qualified stock purchase. One 
type of election, under section 338(g), is available to the purchasing 
corporation. Another type of election, under section 338(h)(10), is, in 
more limited circumstances, available jointly to the purchasing 
corporation and the sellers of the stock. (Rules concerning eligibility 
for these elections are contained in Secs. 1.338-2, 1.338-3, and 
1.338(h)(10)-1.) Although target is a single corporation under 
corporate law, if a section 338 election is made, then two separate 
corporations, old target and new target, generally are considered to 
exist for purposes of subtitle A of the Internal Revenue Code. Old 
target is treated as transferring all of its assets to an unrelated 
person in exchange for consideration that includes the assumption of, 
or taking subject to, liabilities, and new target is treated as 
acquiring all of its assets from an unrelated person in exchange for 
consideration that includes the assumption of or taking subject to 
liabilities. (Such transaction is, without regard to its 
characterization for Federal income tax purposes, referred to as the 
deemed asset sale and the income tax consequences thereof as the deemed 
sale gain.) If a section 338(h)(10) election is made, old target is 
also deemed to liquidate following the deemed asset sale.
    (2) Application of other rules of law. Other rules of law apply to 
determine the tax consequences to the parties as if they had actually 
engaged in the transactions deemed to occur under section 338 and the 
regulations hereunder except to the extent otherwise provided in the 
regulations hereunder. See also Sec. 1.338-6(c)(2). Other rules of law 
may characterize the transaction as something other than or in addition 
to a sale and purchase of assets; however, it must be a taxable 
transaction. For example, if target is an insurance company for which a 
section 338 election is made, the deemed asset

[[Page 43478]]

sale would be characterized and taxed as an assumption-reinsurance 
transaction under applicable Federal income tax law. See Sec. 1.817-
4(d).
    (3) Overview. Definitions and special nomenclature and rules for 
making the section 338 election are provided in Sec. 1.338-2. 
Qualification for the section 338 election is addressed in Sec. 1.338-
3. The amount for which old target is treated as selling all of its 
assets (the aggregate deemed sale price, or ADSP) is addressed in 
Sec. 1.338-4. The amount for which new target is deemed to have 
purchased all its assets (the adjusted grossed-up basis, or AGUB) is 
addressed in Sec. 1.338-5. Section 1.338-6 addresses allocation both of 
ADSP among the assets old target is deemed to have sold and of AGUB 
among the assets new target is deemed to have purchased. Section 1.338-
7 addresses allocation of ADSP or AGUB when those amounts change after 
the close of new target's first taxable year. Asset and stock 
consistency are addressed in Sec. 1.338-8. International aspects of 
section 338 are covered in Sec. 1.338-9. Rules for the filing of 
returns are provided in Sec. 1.338-10. Eligibility for and treatment of 
section 338(h)(10) elections is addressed in Sec. 1.338(h)(10)-1.
    (b) Treatment of target under other provisions of the Internal 
Revenue Code--(1) General rule for subtitle A. Except as provided in 
this section, new target is treated as a new corporation that is 
unrelated to old target for purposes of subtitle A of the Internal 
Revenue Code. Thus--
    (i) New target is not considered related to old target for purposes 
of section 168 and may make new elections under section 168 without 
taking into account the elections made by old target; and
    (ii) New target may adopt, without obtaining prior approval from 
the Commissioner, any taxable year that meets the requirements of 
section 441 and any method of accounting that meets the requirements of 
section 446. Notwithstanding Sec. 1.441-1T(b)(2), a new target may 
adopt a taxable year on or before the last day for making the election 
under section 338 by filing its first return for the desired taxable 
year on or before that date.
    (2) Exceptions for subtitle A. New target and old target are 
treated as the same corporation for purposes of--
    (i) The rules applicable to employee benefit plans (including those 
plans described in sections 79, 104, 105, 106, 125, 127, 129, 132, 137, 
and 220), qualified pension, profit-sharing, stock bonus and annuity 
plans (sections 401(a) and 403(a)), simplified employee pensions 
(section 408(k)), tax qualified stock option plans (sections 422 and 
423), welfare benefit funds (sections 419, 419A, 512(a)(3), and 4976), 
voluntary employee benefit associations (section 501(c)(9) and the 
regulations thereunder);
    (ii) Sections 1311 through 1314 (relating to the mitigation of the 
effect of limitations) if a section 338(h)(10) election is not made for 
target;
    (iii) Section 108(e)(5) (relating to the reduction of purchase 
money debt);
    (iv) Section 45A (relating to the Indian Employment Credit), 
section 51 (relating to the Work Opportunity Credit), section 51A 
(relating to the Welfare to Work Credit), and section 1396 (relating to 
the Empowerment Zone Act);
    (v) Sections 401(h) and 420 (relating to medical benefits for 
retirees);
    (vi) Section 414 (relating to definitions and special rules); and
    (vii) Any other provision designated in the Internal Revenue 
Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of 
this chapter (relating to the Internal Revenue Bulletin). See 
Sec. 1.1001-3(e)(4)(F) providing that an election under section 338 
does not result in the substitution of a new obligor on target's debt.
    (3) General rule for other provisions of the Internal Revenue Code. 
Except as provided in the regulations under section 338 or in the 
Internal Revenue Bulletin by the Internal Revenue Service (see 
Sec. 601.601(d)(2)(ii) of this chapter), new target is treated as a 
continuation of old target for purposes other than subtitle A of the 
Internal Revenue Code. For example--
    (i) New target is liable for old target's Federal income tax 
liabilities, including the tax liability for the deemed sale gain and 
those tax liabilities of the other members of any consolidated group 
that included old target that are attributable to taxable years in 
which those corporations and old target joined in the same consolidated 
return (see Sec. 1.1502-6(a));
    (ii) Wages earned by the employees of old target are considered 
wages earned by such employees from new target for purposes of sections 
3101 and 3111 (Federal Insurance Contributions Act) and section 3301 
(Federal Unemployment Tax Act); and
    (iii) Old target and new target must use the same employer 
identification number.
    (c) Anti-abuse rule--(1) In general. For purposes of applying the 
residual method of Secs. 1.338-0 through 1.338-10, 1.338(h)(10)-1, and 
1.338(i)-1, the Commissioner is authorized to treat any property 
(including cash) transferred by old target in connection with the 
transactions resulting in the application of the residual method as, 
nonetheless, property of target at the close of the acquisition date if 
the property so transferred, within 24 months after the deemed asset 
sale, is owned by new target, or is owned, directly or indirectly, by a 
member of the affiliated group of which new target is a member and 
continues after the election to be held or used to more than an 
insignificant extent in connection with one or more of the activities 
of new target. The Commissioner is authorized to treat any property 
(including cash) transferred to old target in connection with the 
transactions resulting in the application of the residual method as, 
nonetheless, not being property of target at the close of the 
acquisition date if the property so transferred by the transferor is, 
within 24 months after the deemed asset sale, not owned by new target 
but owned, directly or indirectly, by a member of the affiliated group 
of which new target is a member or owned by new target but held or used 
to more than an insignificant extent in connection with an activity 
conducted, directly or indirectly, by another member of the affiliated 
group of which new target is a member in combination with other 
property acquired, directly or indirectly, from the transferor of the 
property (or a member of the same affiliated group) to old target. For 
purposes of this paragraph (c)(1), an interest in an entity is 
considered held or used in connection with an activity if property of 
the entity is so held or used. The authority under this paragraph 
(c)(1) includes the making of any necessary correlative adjustments.
    (2) Examples. The following examples illustrate this paragraph (c):

    Example 1. Prior to a qualified stock purchase under section 
338, target transfers one of its assets to a related party. The 
purchasing corporation then purchases the target stock and also 
purchases the transferred asset from the related party. After its 
purchase of target, the purchasing corporation and target are 
members of the same affiliated group. A section 338 election is 
made. Under an arrangement with the purchaser, target continues to 
use the separately transferred asset to more than an insignificant 
extent in connection with its own activities. Applying the anti-
abuse rule of this paragraph (c), the Commissioner may consider 
target to own the transferred asset for purposes of applying section 
338 and its allocation rules.
    Example 2. Target (T) owns all the stock of T1. T1 leases 
intellectual property to T, which T uses in connection with its own 
activities. P, a purchasing corporation, wishes to buy the T-T1 
chain of corporations. P, in connection with its planned purchase of 
the T stock, contracts to consummate a purchase of all the stock of 
T1

[[Page 43479]]

on March 1 and of all the stock of T on March 2. Section 338 
elections are thereafter made for both T and T1. Immediately after 
the purchases, P, T and T1 are members of the same affiliated group. 
T continues to lease the intellectual property from T1 and to use 
the property to more than an insignificant extent in connection with 
its own activities. Thus, an asset of T, the T1 stock, was removed 
from T's own assets prior to the qualified stock purchase of the T 
stock, T1's own assets are used after the deemed asset sale in 
connection with T's own activities, and the T1 stock is after the 
deemed asset sale owned by P, a member of the same affiliated group 
of which T is a member. Applying the anti-abuse rule of this 
paragraph (c), the Commissioner may, for purposes of application of 
section 338 both to T and to T1, consider P to have bought only the 
stock of T, with T at the time of the qualified stock purchases of 
both T and T1 (the qualified stock purchase of T1 being triggered by 
the deemed sale under section 338 of T's assets) owning T1. The 
Commissioner would accordingly apply section 338 first at the T 
level and then at the T1 level.


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

    (a) Scope. This section prescribes rules relating to elections 
under section 338.
    (b) Nomenclature. For purposes of the regulations under section 338 
(except as otherwise provided):
    (1) T is a domestic target corporation that has only one class of 
stock outstanding. Old T refers to T for periods ending on or before 
the close of T's acquisition date; new T refers to T for subsequent 
periods.
    (2) P is the purchasing corporation.
    (3) The P group is an affiliated group of which P is a member.
    (4) P1, P2, etc., are domestic corporations that are members of the 
P group.
    (5) T1, T2, etc., are domestic corporations that are target 
affiliates of T. These corporations (T1, T2, etc.) have only one class 
of stock outstanding and may also be targets.
    (6) S is a domestic corporation (unrelated to P and B) that owns T 
prior to the purchase of T by P. (S is referred to in cases in which it 
is appropriate to consider the effects of having all of the outstanding 
stock of T owned by a domestic corporation.)
    (7) A, a U.S. citizen or resident, is an individual (unrelated to P 
and B) who owns T prior to the purchase of T by P. (A is referred to in 
cases in which it is appropriate to consider the effects of having all 
of the outstanding stock of T owned by an individual who is a U.S. 
citizen or resident. Ownership of T by A and ownership of T by S are 
mutually exclusive circumstances.)
    (8) B, a U.S. citizen or resident, is an individual (unrelated to 
T, S, and A) who owns the stock of P.
    (9) F, used as a prefix with the other terms in this paragraph (b), 
connotes foreign, rather than domestic, status. For example, FT is a 
foreign corporation (as defined in section 7701(a)(5)) and FA is an 
individual other than a U.S. citizen or resident.
    (10) CFC, used as a prefix with the other terms in this paragraph 
(b) referring to a corporation, connotes a controlled foreign 
corporation (as defined in section 957, taking into account section 
953(c)). A corporation identified with the prefix F may be a controlled 
foreign corporation. The prefix CFC is used when the corporation's 
status as a controlled foreign corporation is significant.
    (c) Definitions. For purposes of the regulations under section 338 
(except as otherwise provided):
    (1) Acquisition date. The term acquisition date has the same 
meaning as in section 338(h)(2).
    (2) Acquisition date assets. Acquisition date assets are the assets 
of the target held at the beginning of the day after the acquisition 
date (other than assets that were not assets of old target).
    (3) Affiliated group. The term affiliated group has the same 
meaning as in section 338(h)(5). Corporations are affiliated on any day 
they are members of the same affiliated group.
    (4) Common parent. The term common parent has the same meaning as 
in section 1504.
    (5) Consistency period. The consistency period is the period 
described in section 338(h)(4)(A) unless extended pursuant to 
Sec. 1.338-8(j)(1).
    (6) Deemed asset sale. The deemed asset sale is the transaction 
described in Sec. 1.338-1(a)(1) that is deemed to occur for purposes of 
subtitle A of the Internal Revenue Code if a section 338 election is 
made.
    (7) Deemed sale gain. Deemed sale gain refers to, in the aggregate, 
the Federal income tax consequences (generally, the income, gain, 
deduction, and loss) of the deemed asset sale. Deemed sale gain also 
refers to the Federal income tax consequences of the transfer of a 
particular asset in the deemed asset sale.
    (8) Deemed sale return. The deemed sale return is the return on 
which target's deemed sale gain is reported that does not include any 
other items of target. Target files a deemed sale return when a section 
338 election (but not a section 338(h)(10) election) is filed for 
target and target is a member of a selling group (defined in paragraph 
(c)(16) of this section) that files a consolidated return for the 
period that includes the acquisition date or is an S corporation. See 
Sec. 1.338-10.
    (9) Domestic corporation. A domestic corporation is a corporation--
    (i) That is domestic within the meaning of section 7701(a)(4) or 
that is treated as domestic for purposes of subtitle A of the Internal 
Revenue Code (e.g., to which an election under section 953(d) or 
1504(d) applies); and
    (ii) That is not a DISC, a corporation described in section 
1248(e), or a corporation to which an election under section 936 
applies.
    (10) Old target's final return. Old target's final return is the 
income tax return of old target for the taxable year ending at the 
close of the acquisition date that includes the deemed sale gain. If 
the disaffiliation rule of Sec. 1.338-10(a)(2)(i) applies or if target 
is an S corporation, target's deemed sale return is considered old 
target's final return.
    (11) Purchasing corporation. The term purchasing corporation has 
the same meaning as in section 338(d)(1). The purchasing corporation 
may also be referred to as purchaser. Unless otherwise provided, any 
reference to the purchasing corporation is a reference to all members 
of the affiliated group of which the purchasing corporation is a 
member. See sections 338(h)(5) and (8). Also, unless otherwise 
provided, any reference to the purchasing corporation is, with respect 
to a deemed purchase of stock under section 338(a)(2), a reference to 
new target with respect to its own deemed purchase of stock in another 
target.
    (12) Qualified stock purchase. The term qualified stock purchase 
has the same meaning as in section 338(d)(3).
    (13) Related persons. Two persons are related if stock in a 
corporation owned by one of the persons would be attributed under 
section 318(a) (other than section 318(a)(4)) to the other.
    (14) Section 338 election. A section 338 election is an election to 
apply section 338(a) to target. A section 338 election is made by 
filing a statement of section 338 election pursuant to Sec. 1.338-2(d). 
The form on which this statement is filed is referred to in the 
regulations under section 338 as the Form 8023 Elections Under Section 
338 for Corporations Making Qualified Stock Purchases.
    (15) Section 338(h)(10) election. A section 338(h)(10) election is 
an election to apply section 338(h)(10) to target. A section 338(h)(10) 
election is made by making a joint election for target under 
Sec. 1.338(h)(10)-1.
    (16) Selling group. The selling group is the affiliated group (as 
defined in section 1504) eligible to file a

[[Page 43480]]

consolidated return that includes target for the taxable period in 
which the acquisition date occurs. However, a selling group is not an 
affiliated group of which target is the common parent on the 
acquisition date.
    (17) Target; old target; new target. Target is the target 
corporation as defined in section 338(d)(2). Old target refers to 
target for periods ending on or before the close of target's 
acquisition date. New target refers to target for subsequent periods.
    (18) Target affiliate. The term target affiliate has the same 
meaning as in section 338(h)(6) (applied without section 
338(h)(6)(B)(i)). Thus, a corporation described in section 
338(h)(6)(B)(i) is considered a target affiliate for all purposes of 
section 338. If a target affiliate is acquired in a qualified stock 
purchase, it is also a target.
    (19) 12-Month acquisition period. The 12-month acquisition period 
is the period described in section 338(h)(1), unless extended pursuant 
to Sec. 1.338-8(j)(2).
    (d) Time and manner of making election. The purchasing corporation 
makes a section 338 election for target by filing a statement of 
section 338 election on Form 8023 in accordance with the instructions 
to the form. The section 338 election must be made not later than the 
15th day of the 9th month beginning after the month in which the 
acquisition date occurs. A section 338 election is irrevocable. See 
Sec. 1.338(h)(10)-1(c)(2) for section 338(h)(10) elections.
    (e) Special rules for foreign corporations or DISCs--(1) Elections 
by certain foreign purchasing corporations--(i) General rule. A 
qualifying foreign purchasing corporation is not required to file a 
statement of section 338 election for a qualifying foreign target 
before the earlier of 3 years after the acquisition date and the 180th 
day after the close of the purchasing corporation's taxable year within 
which a triggering event occurs.
    (ii) Qualifying foreign purchasing corporation. A purchasing 
corporation is a qualifying foreign purchasing corporation only if, 
during the acquisition period of a qualifying foreign target, all the 
corporations in the purchasing corporation's affiliated group are 
foreign corporations that are not subject to United States tax.
    (iii) Qualifying foreign target. A target is a qualifying foreign 
target only if target and its target affiliates are foreign 
corporations that, during target's acquisition period, are not subject 
to United States tax (and will not become subject to United States tax 
during such period because of a section 338 election). A target 
affiliate is taken into account for purposes of the preceding sentence 
only if, during target's 12-month acquisition period, it is or becomes 
a member of the affiliated group that includes the purchasing 
corporation.
    (iv) Triggering event. A triggering event occurs in the taxable 
year of the qualifying foreign purchasing corporation in which either 
that corporation or any corporation in its affiliated group becomes 
subject to United States tax.
    (v) Subject to United States tax. For purposes of this paragraph 
(e)(1), a foreign corporation is considered subject to United States 
tax--
    (A) For the taxable year for which that corporation is required 
under Sec. 1.6012 2(g)-(other than Sec. 1.6012-2(g)(2)(i)(B)(2)) to 
file a United States income tax return; or
    (B) For the period during which that corporation is a controlled 
foreign corporation, a passive foreign investment company for which an 
election under section 1295 is in effect, a foreign investment company, 
or a foreign corporation the stock ownership of which is described in 
section 552(a)(2).
    (2) Acquisition period. For purposes of this paragraph (e), the 
term acquisition period means the period beginning on the first day of 
the 12-month acquisition period and ending on the acquisition date.
    (3) Statement of section 338 election may be filed by United States 
shareholders in certain cases. The United States shareholders (as 
defined in section 951(b)) of a foreign purchasing corporation that is 
a controlled foreign corporation (as defined in section 957 (taking 
into account section 953(c))) may file a statement of section 338 
election on behalf of the purchasing corporation if the purchasing 
corporation is not required under Sec. 1.6012-2(g) (other than 
Sec. 1.6012-2(g)(2)(i)(B)(2)) to file a United States income tax return 
for its taxable year that includes the acquisition date. Form 8023 must 
be filed as described in the form and its instructions and also must be 
attached to the Form 5471 (information return with respect to a foreign 
corporation) filed with respect to the purchasing corporation by each 
United States shareholder for the purchasing corporation's taxable year 
that includes the acquisition date (or, if paragraph (e)(1)(i) of this 
section applies to the election, for the purchasing corporation's 
taxable year within which it becomes a controlled foreign corporation). 
The provisions of Sec. 1.964-1(c) (including Sec. 1.964-1(c)(7)) do not 
apply to an election made by the United States shareholders.
    (4) Notice requirement for U.S. persons holding stock in foreign 
market--(i) General rule. If a target subject to a section 338 election 
was a controlled foreign corporation, a passive foreign investment 
company, or a foreign personal holding company at any time during the 
portion of its taxable year that ends on its acquisition date, the 
purchasing corporation must deliver written notice of the election (and 
a copy of Form 8023, its attachments and instructions) to--
    (A) Each U.S. person (other than a member of the affiliated group 
of which the purchasing corporation is a member (the purchasing group 
member)) that, on the acquisition date of the foreign target, holds 
stock in the foreign target; and
    (B) Each U.S. person (other than a purchasing group member) that 
sells stock in the foreign target to a purchasing group member during 
the foreign target's 12-month acquisition period.
    (ii) Limitation. The notice requirement of this paragraph (e)(4) 
applies only where the section 338 election for the foreign target 
affects income, gain, loss, deduction, or credit of the U.S. person 
described in paragraph (e)(4)(i) of this section under section 551, 
951, 1248, or 1293.
    (iii) Form of notice. The notice to U.S. persons must be identified 
prominently as a notice of section 338 election and must--
    (A) Contain the name, address, and employer identification number 
(if any) of, and the country (and, if relevant, the lesser political 
subdivision) under the laws of which is organized, the purchasing 
corporation and the relevant target (i.e., target the stock of which 
the particular U.S. person held or sold under the circumstances 
described in paragraph (e)(4)(i) of this section);
    (B) Identify those corporations as the purchasing corporation and 
the foreign target, respectively; and
    (C) Contain the following declaration (or a substantially similar 
declaration): THIS DOCUMENT SERVES AS NOTICE

[[Page 43481]]

OF AN ELECTION UNDER SECTION 338 FOR THE ABOVE CITED FOREIGN TARGET THE 
STOCK OF WHICH YOU EITHER HELD OR SOLD UNDER THE CIRCUMSTANCES 
DESCRIBED IN TREASURY REGULATIONS SECTION 1.338-2(e)(4). FOR POSSIBLE 
UNITED STATES FEDERAL INCOME TAX CONSEQUENCES UNDER SECTION 551, 951, 
1248, OR 1293 OF THE INTERNAL REVENUE CODE OF 1986 THAT MAY APPLY TO 
YOU, SEE TREASURY REGULATIONS SECTION 1.338-9(b). YOU MAY BE REQUIRED 
TO ATTACH THE INFORMATION ATTACHED TO THIS NOTICE TO CERTAIN RETURNS.
    (iv) Timing of notice. The notice required by this paragraph (e)(4) 
must be delivered to the U.S. person on or before the later of the 
120th day after the acquisition date of the particular target or the 
day on which Form 8023 is filed. The notice is considered delivered on 
the date it is mailed to the proper address (or an address similar 
enough to complete delivery), unless the date it is mailed cannot be 
reasonably determined. The date of mailing will be determined under the 
rules of section 7502. For example, the date of mailing is the date of 
U.S. postmark or the applicable date recorded or marked by a designated 
delivery service.
    (v) Consequence of failure to comply. A statement of section 338 
election is not valid if timely notice is not given to one or more U.S. 
persons described in this paragraph (e)(4). If the form of notice fails 
to comply with all requirements of this paragraph (e)(4), the section 
338 election is valid, but the waiver rule of Sec. 1.338-10(b)(1) does 
not apply.
    (vi) Good faith effort to comply. The purchasing corporation will 
be considered to have complied with this paragraph (e)(4), even though 
it failed to provide notice or provide timely notice to each person 
described in this paragraph (e)(4), if the Commissioner determines that 
the purchasing corporation made a good faith effort to identify and 
provide timely notice to those U.S. persons.


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

    (a) Scope. This section provides rules on whether certain 
acquisitions of stock are qualified stock purchases and on other 
miscellaneous issues under section 338.
    (b) Rules relating to qualified stock purchases--(1) Purchasing 
corporation requirement. An individual cannot make a qualified stock 
purchase of target. Section 338(d)(3) requires, as a condition of a 
qualified stock purchase, that a corporation purchase the stock of 
target. If an individual forms a corporation (new P) to acquire target 
stock, new P can make a qualified stock purchase of target if new P is 
considered for tax purposes to purchase the target stock. Facts that 
may indicate that new P does not purchase the target stock include new 
P merging downstream into target, liquidating, or otherwise disposing 
of the target stock following the purported qualified stock purchase.
    (2) Purchase--(i) Definition. The term purchase has the same 
meaning as in section 338(h)(3).
    (ii) Purchase of target. A purchase of a share of target stock 
occurs so long as more than a nominal amount is paid for such share.
    (iii) Purchase of target affiliate. Stock in a target affiliate 
acquired by new target in the deemed asset sale of target's assets is 
considered purchased if, under general principles of tax law, new 
target is considered to own stock of the target affiliate meeting the 
requirements of section 1504(a)(2), notwithstanding that no amount may 
be allocated to target's stock in the target affiliate.
    (3) Acquisitions of stock from related corporations--(i) In 
general. Stock acquired by a purchasing corporation from a related 
corporation (R) is generally not considered acquired by purchase. See 
section 338(h)(3)(A)(iii).
    (ii) Time for testing relationship. For purposes of section 
338(h)(3)(A)(iii), a purchasing corporation is treated as related to 
another person if the relationship specified in section 
338(h)(3)(A)(iii) exists--
    (A) In the case of a single transaction, immediately after the 
purchase of Target stock;
    (B) In the case of a series of acquisitions otherwise constituting 
a qualified stock purchase within the meaning of section 338(d)(3), 
immediately after the last acquisition in such series; and
    (C) In the case of a series of transactions effected pursuant to an 
integrated plan to dispose of Target stock, immediately after the last 
transaction in such series.
    (iii) Cases where section 338(h)(3)(C) applies--acquisitions 
treated as purchases. If section 338(h)(3)(C) applies and the 
purchasing corporation is treated as acquiring stock by purchase from 
R, solely for purposes of determining when the stock is considered 
acquired, target stock acquired from R is considered to have been 
acquired by the purchasing corporation on the day on which the 
purchasing corporation is first considered to own that stock under 
section 318(a) (other than section 318(a)(4)).
    (iv) Examples. The following examples illustrate this paragraph 
(b)(3):

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

[[Page 43482]]

from B (the sole shareholder of P). That R stock is not acquired by 
purchase. See section 338(h)(3)(A)(iii). On that date, R owns 4 of 
the 100 shares of T stock. On June 1 of Year 1, P purchases an 
additional 25 percent in value of the R stock, and on January 1 of 
Year 2, P purchases another 25 percent in value of the R stock. On 
June 1 of Year 2, R acquires an additional 16 shares of the T stock. 
On December 1 of Year 2, P purchases 68 shares of the T stock from 
an unrelated person and 12 of the 20 shares of the T stock held by 
R.
    (ii) Of the 12 shares of the T stock purchased by P from R on 
December 1 of Year 2, 2 of those shares are deemed to have been 
acquired by P on June 1 of Year 1, the date on which 2 of the 4 
shares of the T stock held by R on that date were first considered 
owned by P under section 318(a)(2)(C) (i.e., 4 x .5). For purposes 
of this attribution, the R stock need not be acquired by P by 
purchase. See section 338(h)(1). (By contrast, the acquisition of 
the T stock by P from R does not qualify as a purchase unless P has 
acquired at least 50 percent in value of the R stock by purchase. 
Section 338(h)(3)(C)(i).) Of the remaining 10 shares of the T stock 
purchased by P from R on December 1 of Year 2, 1 of those shares is 
deemed to have been acquired by P on January 1 of Year 2, the date 
on which an additional 1 share of the 4 shares of the T stock held 
by R on that date was first considered owned by P under section 
318(a)(2)(C) (i.e., (4 x .75)--2). The remaining 9 shares of the T 
stock purchased by P from R on December 1 of Year 2, are deemed to 
have been acquired by P on June 1 of Year 2, the date on which an 
additional 12 shares of the T stock held by R on that date were 
first considered owned by P under section 318(a)(2)(C) (i.e., 
(20 x .75)--3). Because a qualified stock purchase of T by P is made 
on December 1 of Year 2, only if all 12 shares of the T stock 
purchased by P from R on that date are considered acquired during a 
12-month period ending on that date (so that, in conjunction with 
the 68 shares of the T stock P purchased on that date from the 
unrelated person, 80 of T's 100 shares are acquired by P during a 
12-month period) and because 2 of those 12 shares are considered to 
have been acquired by P more than 12 months before December 1 of 
Year 2 (i.e., on June 1 of Year 1), a qualified stock purchase is 
not made. (Under Sec. 1.338-8(j)(2), for purposes of applying the 
consistency rules, P is treated as making a qualified stock purchase 
of T if, pursuant to an arrangement, P purchases T stock satisfying 
the requirements of section 1504(a)(2) over a period of more than 12 
months.)
    Example 4. Assume the same facts as in Example 3, except that on 
February 1 of Year 1, P acquires 25 percent in value of the R stock 
by purchase. The result is the same as in Example 3. 

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

    Example 1. A owns all of the T stock. T owns 50 of the 100 
shares of X stock. The other 50 shares of X stock are owned by 
corporation Y, which is unrelated to A, T, or P. On January 1 of 
Year 1, P makes a qualified stock purchase of T from A and makes a 
section 338 election for T. On December 1 of Year 1, P purchases the 
50 shares of X stock held by Y. A qualified stock purchase of X is 
made on December 1 of Year 1, because the deemed purchase of 50 
shares of X stock by new T because of the section 338 election for T 
and the actual purchase of 50 shares of X stock by P are treated as 
purchases made by one corporation. Section 338(h)(8). For purposes 
of determining whether those purchases occur within a 12-month 
acquisition period as required by section 338(d)(3), T is deemed to 
purchase its X stock on T's acquisition date, i.e., January 1 of 
Year 1.
    Example 2. On January 1 of Year 1, P makes a qualified stock 
purchase of T and makes a section 338 election for T. On that day, T 
sells all of the stock of T1 to A. Although T held all of the T1 
stock on T's acquisition date, T is not considered to have purchased 
the T1 stock because of the section 338 election for T. In order for 
T to be treated as purchasing the T1 stock, T must hold the T1 stock 
when T's deemed asset sale occurs. The deemed asset sale is 
considered the last transaction of old T at the close of T's 
acquisition date. Accordingly, the T1 stock actually disposed of by 
T on the acquisition date is not included in the deemed asset sale. 
Thus, T does not make a qualified stock purchase of T1.

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

    Example 1. QSP on stock purchase date; redemption from unrelated 
person during 12-month period. A owns all 100 shares of T stock. On 
January 1 of Year 1, P purchases 40 shares of the T stock from A. On 
July 1 of Year 1, T redeems 25 shares from A. On December 1 of Year 
1, P purchases 20 shares of the T stock from A. P makes a qualified 
stock purchase of T on December 1 of Year 1, because the 60 shares 
of T stock purchased by P within the 12-month period ending on that 
date satisfy the 80-percent ownership requirements of section 
338(d)(3) (i.e., 60/75 shares), determined by taking into account 
the redemption of 25 shares.
    Example 2. QSP on stock redemption date; redemption from 
unrelated person during 12-month period. The facts are the same as 
in Example 1, except that P purchases 60 shares of T stock on 
January 1 of Year 1 and none on December 1 of Year 1. P makes a 
qualified stock purchase of T on July 1 of Year 1, because that is 
the first day on which the T stock purchased by P within the 
preceding 12-month period satisfies the 80-percent ownership 
requirements of section 338(d)(3) (i.e., 60/75 shares), determined 
by taking into account the redemption of 25 shares.
    Example 3. Redemption from purchasing corporation not taken into 
account. On December 15 of Year 1, T redeems 30 percent of its stock 
from P. The redeemed stock was

[[Page 43483]]

held by P for several years and constituted P's total interest in T. 
On December 1 of Year 2, P purchases the remaining T stock from A. P 
does not make a qualified stock purchase of T on December 1 of Year 
2. For purposes of the 80-percent ownership requirements of section 
338(d)(3), the redemption of P's T stock on December 15 of Year 1 is 
not taken into account as a reduction in T's outstanding stock.
    Example 4. Redemption from related person taken into account. On 
January 1 of Year 1, P purchases 60 of the 100 shares of X stock. On 
that date, X owns 40 of the 100 shares of T stock. On April 1 of 
Year 1, T redeems X's T stock and P purchases the remaining 60 
shares of T stock from an unrelated person. For purposes of the 80-
percent ownership requirements of section 338(d)(3), the redemption 
of the T stock from X (a person related to P) is taken into account 
as a reduction in T's outstanding stock. If P had purchased the 40 
redeemed shares from X on April 1 of Year 1, all 40 of the shares 
would have been considered purchased (because of section 
338(h)(3)(C)(i)) during the 12-month period ending on April 1 of 
Year 1 (24 of the 40 shares would have been considered purchased by 
P on January 1 of Year 1 and the remaining 16 shares would have been 
considered purchased by P on April 1 of Year 1). See paragraph 
(b)(3) of this section. Accordingly, P makes a qualified stock 
purchase of T on April 1 of Year 1, because the 60 shares of T stock 
purchased by P on that date satisfy the 80-percent ownership 
requirements of section 338(d)(3) (i.e., 60/60 shares), determined 
by taking into account the redemption of 40 shares.

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

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

    (2) Post-acquisition elimination of the purchasing corporation. An 
election under section 338 may be made for target after the acquisition 
of assets of the purchasing corporation by another corporation in a 
transaction described in section 381(a), provided that the purchasing 
corporation is considered for tax purposes as the purchaser of the 
target stock. The acquiring corporation in the section 381(a) 
transaction may make an election under section 338 for target.
    (3) Consequences of post-acquisition elimination of target--(i) 
Scope. The rules of this paragraph (c)(3) apply to the transfer of 
target assets to the purchasing corporation (or another member of the 
same affiliated group as the purchasing corporation) (the transferee) 
following a qualified stock purchase of target stock, if the purchasing 
corporation does not make a section 338 election for target. 
Notwithstanding the rules of this paragraph (c)(3), section 354(a) (and 
so much of section 356 as relates to section 354) cannot apply to any 
person other than the purchasing corporation or another member of the 
same affiliated group as the purchasing corporation unless the transfer 
of target assets is pursuant to a reorganization as determined without 
regard to this paragraph (c)(3).
    (ii) Continuity of interest. By virtue of section 338, in 
determining whether the continuity of interest requirement of 
Sec. 1.368-1(b) is satisfied on the transfer of assets from target to 
the transferee, the purchasing corporation's target stock acquired in 
the qualified stock purchase represents an interest on the part of a 
person who was an owner of the target's business enterprise prior to 
the transfer that can be continued in a reorganization.
    (iii) Control requirement. By virtue of section 338, the 
acquisition of target stock in the qualified stock purchase will not 
prevent the purchasing corporation from qualifying as a shareholder of 
the target transferor for the purpose of determining whether, 
immediately after the transfer of target assets, a shareholder of the 
transferor is in control of the corporation to which the assets are 
transferred within the meaning of section 368(a)(1)(D).
    (iv) Example. The following example illustrates this paragraph 
(c)(3):

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

[[Page 43484]]

without regard to Sec. 1.338-3(c)(3). Under general principles of 
tax law applicable to reorganizations, the continuity of interest 
requirement is not satisfied because P's stock purchase and the 
merger of T into X are pursuant to an integrated transaction in 
which A, the owner of 85 percent of the stock of T, received solely 
cash in exchange for A's T stock. See, e.g., Yoc Heating v. 
Commissioner, 61 T.C. 168 (1973); Kass v. Commissioner, 60 T.C. 218 
(1973), aff'd, 491 F.2d 749 (3d Cir. 1974). Thus, the requisite 
continuity of interest under Sec. 1.368-1(b) is lacking and section 
354 does not apply to K's exchange of T stock for X stock. K 
recognizes gain or loss, if any, pursuant to section 1001(c) with 
respect to its T stock.


Secs. 1.338-4 and 1.338-5  [Redesignated as Secs. 1.338-8 and 1.338-9]

    Par. 3. Sections 1.338-4 and 1.338-5 are redesignated as 
Secs. 1.338-8 and 1.338-9, respectively.
    Par. 4. New Secs. 1.338-4 and 1.338-5 are added to read as follows:


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

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

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

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

    Example. T has two classes of stock outstanding, voting common 
stock and preferred stock not taken into account for purposes of 
section 1504(a)(2). On March 1 of Year 1, P purchases 40 percent of 
the outstanding T stock from S1 for $500, 20 percent of the 
outstanding T stock from S2 for $225, and 20 percent of the 
outstanding T stock from S3 for $275. On that date, the fair market 
value of all the T voting common stock is $1,250 and the preferred 
stock $750. S1, S2, and S3 respectively incur $40, $35, and $25 of 
selling costs. S1 continues to own the remaining 20 percent of the 
outstanding T stock. The grossed-up amount realized on the sale to P 
of P's recently purchased T stock is calculated as follows: The 
total amount realized (without regard to selling costs) is $1,000 
(500 + 225 + 275). The percentage of T stock by value on the 
acquisition date attributable to the recently purchased T stock is 
50% (1,000/(1,250 + 750)). The selling costs are $100 (40 + 35 + 
25). The grossed-up amount realized is $1,900 (1,000/.5 -100).

    (d) Liabilities of old target--(1) In general. The liabilities of 
old target are the liabilities of target (and the liabilities to which 
target's assets are subject) as of the beginning of the day after the 
acquisition date (other than liabilities that were neither liabilities 
of old target nor liabilities to which old target's assets were 
subject). In order to be taken into account in ADSP, a liability must 
be a liability of target that is properly taken into account in amount 
realized under general principles of tax law that would apply if old 
target had sold its assets to an unrelated person for consideration 
that included that person's assumption of, or taking subject to, the 
liability. Thus, ADSP takes into account both tax credit recapture 
liability arising because of the

[[Page 43485]]

deemed asset sale and the tax liability for the deemed sale gain unless 
the tax liability is borne by some person other than the target. For 
example, ADSP would not take into account the tax liability for the 
deemed sale gain when a section 338(h)(10) election is made for a 
target S corporation because the S corporation shareholders bear that 
liability. However, if a target S corporation is subject to a tax under 
section 1374 or 1375, the liability for tax imposed by those sections 
is a liability of target taken into account in ADSP (unless the S 
corporation shareholders expressly assume that liability).
    (2) Time and amount of liabilities. The time for taking into 
account liabilities of old target in determining ADSP and the amount of 
the liabilities taken into account is determined as if old target had 
sold its assets to an unrelated person for consideration that included 
the unrelated person's assumption of or taking subject to the 
liabilities. For example, if no amount of a target liability is 
properly taken into account in amount realized as of the beginning of 
the day after the acquisition date, the liability is not initially 
taken into account in determining ADSP (although it may be taken into 
account at some later date). As a further example, an increase or 
decrease in a liability that does not affect the amount of old target's 
basis, deductions, or noncapital nondeductible items arising from the 
incurrence of the liability is not taken into account in redetermining 
ADSP.
    (3) Interaction with deemed sale gain. Though deemed sale gain 
increases or decreases ADSP by creating or reducing a tax liability, 
the amount of the tax liability itself is a function of the size of the 
deemed sale gain. Thus, the determination of ADSP may require trial and 
error computations.
    (e) Calculation of deemed sale gain. Deemed sale gain on each asset 
is computed by reference to the ADSP allocated to that asset.
    (f) Other rules apply in determining ADSP. ADSP may not be applied 
in such a way as to contravene other applicable rules. For example, a 
capital loss cannot be applied to reduce ordinary income in calculating 
the tax liability on the deemed sale for purposes of determining ADSP.
    (g) Examples. The following examples illustrate this section. For 
purposes of the examples in this paragraph (g), unless otherwise 
stated, T is a calendar year taxpayer that files separate returns and 
that has no loss, tax credit, or other carryovers to Year 1. 
Depreciation for Year 1 is not taken into account. T has no liabilities 
other than the Federal income tax liability resulting from the deemed 
asset sale, and the T shareholders have no selling costs. Assume that 
T's tax rate for any ordinary income or net capital gain resulting from 
the deemed sale of assets is 34 percent and that any capital loss is 
offset by capital gain. On July 1 of Year 1, P purchases all of the 
stock of T and makes a section 338 election for T. The examples are as 
follows:

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

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

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

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

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

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

    (iv) Because, under the preliminary calculations of ADSP, the 
amount to be allocated to the Class I, II, III, IV, V, and VI

[[Page 43486]]

assets does not exceed their aggregate fair market value, no ADSP 
amount is allocated to goodwill. Accordingly, the deemed sale of the 
goodwill results in a capital loss of $3,000. The portion of ADSP 
allocable to the Class V assets is finally determined by taking into 
account this loss as follows:

ADSPV = (G - (I + II)) + L + TR  x  [(II - 
BII) + (ADSPV - BV) + 
(ADSPVII - BVII)]
ADSPV = ($140,000 - ($10,000 + $10,000)) + $50,000 + .34 
x  [($10,000 - $4,000) + (ADSPV - $30,000) + ($0 - 
$3,000)]
ADSPV = $160,820 + .34 ADSPV
.66 ADSPV = $160,820
ADSPV = $243,666.67

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

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

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

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

    (v) Because ADSP as determined exceeds the aggregate fair market 
value of the Class I, II, III, IV, V, and VI assets, the $250,000 
amount preliminarily allocated to the Class V assets is appropriate. 
Thus, the amount of ADSP allocated to Class V assets equals their 
aggregate fair market value ($250,000), and the allocated ADSP 
amount for each Class V asset is its fair market value. Further, 
because there are no Class VI assets, the allocable ADSP amount for 
the Class VII asset (goodwill) is $8,818.18 (the excess of ADSP over 
the aggregate ADSP amounts for the Class I, II, III, IV, V and VI 
assets).
    Example 4. Amount allocated to T1 stock. (i) The facts are the 
same as in Example 2, except that T owns all of the T1 stock 
(instead of the building), and T1's only asset is the building. The 
T1 stock and the building each have a fair market value of $50,000, 
and the building has a basis of $10,000. A section 338 election is 
made for T1 (as well as T), and T1 has no liabilities other than the 
tax liability for the deemed sale gain. T is the common parent of a 
consolidated group filing a final consolidated return described in 
Sec. 1.338 10(a)(1).
    (ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to 
the cash and $10,000 to the actively traded securities.
    (iii) Because T does not recognize any gain on the deemed sale 
of the T1 stock under paragraph (h)(2) of this section, appropriate 
adjustments must be made to reflect accurately the fair market value 
of the T and T1 assets in determining the allocation of ADSP among 
T's Class V assets (including the T1 stock). In preliminarily 
calculating ADSPV in this case, the T1 stock can be disregarded and, 
because T owns all of the T1 stock, the T1 asset can be treated as a 
T asset. Under this assumption, ADSPV is $243,666.67. See paragraph 
(iv) of Example 2.
    (iv) Because the portion of the preliminary ADSP allocable to 
Class V assets ($243,666.67) does not exceed their fair market value 
($250,000), no amount is allocated to Class VII assets for T. 
Further, this amount ($243,666.67) is allocated among T's Class V 
assets in proportion to their fair market values. See paragraph (v) 
of Example 2. Tentatively, $48,733.34 of this amount is allocated to 
the T1 stock.
    (v) The amount tentatively allocated to the T1 stock, however, 
reflects the tax incurred on the deemed sale of the T1 asset equal 
to $13,169.34 (.34  x  ($48,733.34 -$10,000)). Thus, the ADSP 
allocable to the Class V assets of T, and the ADSP allocable to the 
T1 stock, as preliminarily calculated, each must be reduced by 
$13,169.34. Consequently, these amounts, respectively, are 
$230,497.33 and $35,564.00. In determining ADSP for T1, the grossed-
up amount realized on the deemed sale to new T of new T's recently 
purchased T1 stock is $35,564.00.
    (vi) The facts are the same as in paragraph (i) of this Example 
4, except that the T1 building has a $12,500 basis and a $62,500 
value, all of the outstanding T1 stock has a $62,500 value, and T 
owns 80 percent of the T1 stock. In preliminarily calculating 
ADSPv, the T1 stock can be disregarded but, because T 
owns only 80 percent of the T1 stock, only 80 percent of T1 asset 
basis and value should be taken into account in calculating T's 
ADSP. By taking into account 80 percent of these amounts, the 
remaining calculations and results are the same as in paragraphs 
(ii), (iii), (iv), and (v) of this Example 4, except that the 
grossed-up amount realized on the sale of the recently purchased T1 
stock is $44,455.00 ($35,564.00/0.8).

    (h) Deemed sale of target affiliate stock--(1) Scope. This 
paragraph (h) prescribes rules relating to the treatment of gain or 
loss realized on the deemed sale of stock of a target affiliate when a 
section 338 election (but not a section 338(h)(10) election) is made 
for the target affiliate. For purposes of this paragraph (h), the 
definition of domestic corporation in Sec. 1.338-2(c)(9) is applied 
without the exclusion therein for DISCs, corporations described in 
section 1248(e), and corporations to which an election under section 
936 applies.

[[Page 43487]]

    (2) In general. Except as otherwise provided in this paragraph (h), 
if a section 338 election is made for target, target recognizes no gain 
or loss on the deemed sale of stock of a target affiliate having the 
same acquisition date and for which a section 338 election is made if--
    (i) Target directly owns stock in the target affiliate satisfying 
the requirements of section 1504(a)(2);
    (ii) Target and the target affiliate are members of a consolidated 
group filing a final consolidated return described in Sec. 1.338-
10(a)(1); or
    (iii) Target and the target affiliate file a combined return under 
Sec. 1.338-10(a)(4).
    (3) Deemed sale of foreign target affiliate by a domestic target. A 
domestic target recognizes gain or loss on the deemed sale of stock of 
a foreign target affiliate. For the proper treatment of such gain or 
loss, see, e.g., sections 1246, 1248, 1291 et seq., and 338(h)(16) and 
Sec. 1.338-9.
    (4) Deemed sale producing effectively connected income. A foreign 
target recognizes gain or loss on the deemed sale of stock of a foreign 
target affiliate to the extent that such gain or loss is effectively 
connected (or treated as effectively connected) with the conduct of a 
trade or business in the United States.
    (5) Deemed sale of insurance company target affiliate electing 
under section 953(d). A domestic target recognizes gain (but not loss) 
on the deemed sale of stock of a target affiliate that has in effect an 
election under section 953(d) in an amount equal to the lesser of the 
gain realized or the earnings and profits described in section 
953(d)(4)(B).
    (6) Deemed sale of DISC target affiliate. A foreign or domestic 
target recognizes gain (but not loss) on the deemed sale of stock of a 
target affiliate that is a DISC or a former DISC (as defined in section 
992(a)) in an amount equal to the lesser of the gain realized or the 
amount of accumulated DISC income determined with respect to such stock 
under section 995(c). Such gain is included in gross income as a 
dividend as provided in sections 995(c)(2) and 996(g).
    (7) Anti-stuffing rule. If an asset the adjusted basis of which 
exceeds its fair market value is contributed or transferred to a target 
affiliate as transferred basis property (within the meaning of section 
7701(a)(43)) and a purpose of such transaction is to reduce the gain 
(or increase the loss) recognized on the deemed sale of such target 
affiliate's stock, the gain or loss recognized by target on the deemed 
sale of stock of the target affiliate is determined as if such asset 
had not been contributed or transferred.
    (8) Examples. The following examples illustrate this paragraph (h):

    Example 1. (i) P makes a qualified stock purchase of T and makes 
a section 338 election for T. T's sole asset, all of the T1 stock, 
has a basis of $50 and a fair market value of $150. T's deemed 
purchase of the T1 stock results in a qualified stock purchase of T1 
and a section 338 election is made for T1. T1's assets have a basis 
of $50 and a fair market value of $150.
    (ii) T realizes $100 of gain on the deemed sale of the T1 stock, 
but the gain is not recognized because T directly owns stock in T1 
satisfying the requirements of section 1504(a)(2) and a section 338 
election is made for T1.
    (iii) T1 recognizes gain of $100 on the deemed sale of its 
assets.
    Example 2. The facts are the same as in Example 1, except that P 
does not make a section 338 election for T1. Because a section 338 
election is not made for T1, the $100 gain realized by T on the 
deemed sale of the T1 stock is recognized.
    Example 3. (i) P makes a qualified stock purchase of T and makes 
a section 338 election for T. T owns all of the stock of T1 and T2. 
T's deemed purchase of the T1 and T2 stock results in a qualified 
stock purchase of T1 and T2 and section 338 elections are made for 
T1 and T2. T1 and T2 each own 50 percent of the vote and value of T3 
stock. The deemed purchases by T1 and T2 of the T3 stock result in a 
qualified stock purchase of T3 and a section 338 election is made 
for T3. T is the common parent of a consolidated group and all of 
the deemed asset sales are reported on the T group's final 
consolidated return. See Sec. 1.338-10(a)(1).
    (ii) Because T, T1, T2 and T3 are members of a consolidated 
group filing a final consolidated return, no gain or loss is 
recognized by T, T1 or T2 on their respective deemed sales of target 
affiliate stock.
    Example 4. (i) T's sole asset, all of the FT1 stock, has a basis 
of $25 and a fair market value of $150. FT1's sole asset, all of the 
FT2 stock, has a basis of $75 and a fair market value of $150. FT1 
and FT2 each have $50 of accumulated earnings and profits for 
purposes of section 1248(c) and (d). FT2's assets have a basis of 
$125 and a fair market value of $150, and their sale would not 
generate subpart F income under section 951. The sale of the FT2 
stock or assets would not generate income effectively connected with 
the conduct of a trade or business within the United States. FT1 
does not have an election in effect under section 953(d) and neither 
FT1 nor FT2 is a passive foreign investment company.
    (ii) P makes a qualified stock purchase of T and makes a section 
338 election for T. T's deemed purchase of the FT1 stock results in 
a qualified stock purchase of FT1 and a section 338 election is made 
for FT1. Similarly, FT1's deemed purchase of the FT2 stock results 
in a qualified stock purchase of FT2 and a section 338 election is 
made for FT2.
    (iii) T recognizes $125 of gain on the deemed sale of the FT1 
stock under paragraph (h)(3) of this section. FT1 does not recognize 
$75 of gain on the deemed sale of the FT2 stock under paragraph 
(h)(2) of this section. FT2 recognizes $25 of gain on the deemed 
sale of its assets. The $125 gain T recognizes on the deemed sale of 
the FT1 stock is included in T's income as a dividend under section 
1248, because FT1 and FT2 have sufficient earnings and profits for 
full recharacterization ($50 of accumulated earnings and profits in 
FT1, $50 of accumulated earnings and profits in FT2, and $25 of 
deemed sale earnings and profits in FT2). Sec. 1.338-9(b). For 
purposes of sections 901 through 908, the source and foreign tax 
credit limitation basket of $25 of the recharacterized gain on the 
deemed sale of the FT1 stock is determined under section 338(h)(16).


Sec. 1.338 5  Adjusted grossed-up basis.

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

[[Page 43488]]

an increase in the amount realized for recently purchased stock of 
target is taken into account after the acquisition date, any increase 
in tax liability of target for the deemed sale gain is also taken into 
account when AGUB is redetermined. An increase or decrease to one 
element of AGUB may also cause an increase or decrease to another 
element of AGUB. For example, if there is an increase in the amount 
paid or incurred for recently purchased stock after the acquisition 
date, any increase in the basis of nonrecently purchased stock because 
a gain recognition election was made is also taken into account when 
AGUB is redetermined. Increases or decreases with respect to the 
elements of AGUB that are taken into account before the close of new 
target's first taxable year are taken into account for purposes of 
determining AGUB and the basis of target's assets as if they had been 
taken into account at the beginning of the day after the acquisition 
date. Increases or decreases with respect to the elements of AGUB that 
are taken into account after the close of new target's first taxable 
year result in the reallocation of AGUB among target's assets under 
Sec. 1.338-7.
    (iii) Examples. The following examples illustrate this paragraph 
(b)(2):

    Example 1. In Year 1, T, a manufacturer, purchases a customized 
delivery truck from X with purchase money indebtedness having a 
stated principal amount of $100,000. P acquires all of the stock of 
T in Year 3 for $700,000 and makes a section 338 election for T. 
Assume T has no liabilities other than its purchase money 
indebtedness to X. In Year 4, when T is neither insolvent nor in a 
title 11 case, T and X agree to reduce the amount of the purchase 
money indebtedness to $80,000. Assume that the reduction would be a 
purchase price reduction under section 108(e)(5). T and X's 
agreement to reduce the amount of the purchase money indebtedness 
would, under general principles of tax law that would apply if the 
deemed asset sale had actually occurred, change the amount of 
liabilities of old target taken into account in determining its 
basis. Accordingly, AGUB is redetermined at the time of the 
reduction. See paragraph (e)(2) of this section. Thus the purchase 
price reduction affects the basis of the truck only indirectly, 
through the mechanism of Secs. 1.338-6 and 1.338-7. See Sec. 1.338-
4(b)(2)(iii) Example for the effect on ADSP.
    Example 2. T, an accrual basis taxpayer, is a chemical 
manufacturer. In Year 1, T is obligated to remediate environmental 
contamination at the site of one of its plants. Assume that all the 
events have occurred that establish the fact of the liability and 
the amount of the liability can be determined with reasonable 
accuracy but economic performance has not occurred with respect to 
the liability within the meaning of section 461(h). P acquires all 
of the stock of T in Year 1 and makes a section 338 election for T. 
Assume that, if a corporation unrelated to T had actually purchased 
T's assets and assumed T's obligation to remediate the 
contamination, the corporation would not satisfy the economic 
performance requirements until Year 5. Under section 461(h), the 
assumed liability would not be treated as incurred and taken into 
account in basis until that time. The incurrence of the liability in 
Year 5 under the economic performance rules is an increase in the 
amount of liabilities properly taken into account in basis and 
results in the redetermination of AGUB. (Respecting ADSP, compare 
Sec. 1.461-4(d)(5), which provides that economic performance occurs 
for old T as the amount of the liability is properly taken into 
account in amount realized on the deemed asset sale. Thus ADSP is 
not redetermined when new T satisfies the economic performance 
requirements.)
    (c) Grossed-up basis of recently purchased stock. The purchasing 
corporation's grossed-up basis of recently purchased target stock (as 
defined in section 338(b)(6)(A)) is an amount equal to--
    (1) The purchasing corporation's basis in recently purchased target 
stock at the beginning of the day after the acquisition date determined 
without regard to the acquisition costs taken into account in paragraph 
(c)(3) of this section;
    (2) Multiplied by a fraction, the numerator of which is 100 percent 
minus the percentage of target stock (by value, determined on the 
acquisition date) attributable to the purchasing corporation's 
nonrecently purchased target stock, and the denominator of which is the 
percentage of target stock (by value, determined on the acquisition 
date) attributable to the purchasing corporation's recently purchased 
target stock;
    (3) Plus the acquisition costs the purchasing corporation incurred 
in connection with its purchase of the recently purchased stock that 
are capitalized in the basis of such stock (e.g., brokerage commissions 
and any similar costs incurred by the purchasing corporation to acquire 
the stock).
    (d) Basis of nonrecently purchased stock; gain recognition 
election--(1) No gain recognition election. In the absence of a gain 
recognition election under section 338(b)(3) and this section, the 
purchasing corporation retains its basis in the nonrecently purchased 
stock.
    (2) Procedure for making gain recognition election. A gain 
recognition election may be made for nonrecently purchased stock of 
target (or a target affiliate) only if a section 338 election is made 
for target (or the target affiliate). The gain recognition election is 
made by attaching a gain recognition statement to a timely filed Form 
8023 for target. The gain recognition statement must contain the 
information specified in the form and its instructions. The gain 
recognition election is irrevocable. If a section 338(h)(10) election 
is made for target, see Sec. 1.338(h)(10)-1(d)(1) (providing that the 
purchasing corporation is automatically deemed to have made a gain 
recognition election for its nonrecently purchased T stock).
    (3) Effect of gain recognition election--(i) In general. If the 
purchasing corporation makes a gain recognition election, then for all 
purposes of the Internal Revenue Code--
    (A) The purchasing corporation is treated as if it sold on the 
acquisition date the nonrecently purchased target stock for the basis 
amount determined under paragraph (d)(3)(ii) of this section; and
    (B) The purchasing corporation's basis on the acquisition date in 
nonrecently purchased target stock immediately following the deemed 
sale in paragraph (d)(3)(i)(A) of this section is the basis amount.
    (ii) Basis amount. The basis amount is equal to the amount in 
paragraph (c)(1) of this section (the purchasing corporation's basis in 
recently purchased target stock at the beginning of the day after the 
acquisition date determined without regard to the acquisition costs 
taken into account in paragraph (c)(3) of this section) multiplied by a 
fraction the numerator of which is the percentage of target stock (by 
value, determined on the acquisition date) attributable to the 
purchasing corporation's nonrecently purchased target stock and the 
denominator of which is 100 percent minus the numerator amount. Thus, 
if target has a single class of outstanding stock, the purchasing 
corporation's basis in each share of nonrecently purchased target stock 
after the gain recognition election is equal to the average price per 
share of the purchasing corporation's recently purchased target stock.
    (iii) Losses not recognized. Only gains (unreduced by losses) on 
the nonrecently purchased target stock are recognized.
    (iv) Stock subject to election. The gain recognition election 
applies to
    (A) All nonrecently purchased target stock; and
    (B) Any nonrecently purchased stock in a target affiliate having 
the same acquisition date as target if such target affiliate stock is 
held by the purchasing corporation on such date.
    (e) Liabilities of new target--(1) In general. The liabilities of 
new target are the liabilities of target (and the liabilities to which 
target's assets are subject) as of the beginning of the day

[[Page 43489]]

after the acquisition date (other than liabilities that were neither 
liabilities of old target nor liabilities to which old target's assets 
were subject). In order to be taken into account in AGUB, a liability 
must be a liability of target that is properly taken into account in 
basis under general principles of tax law that would apply if new 
target had acquired its assets from an unrelated person for 
consideration that included the assumption of, or taking subject to, 
the liability. See Sec. 1.338-4(d)(1) for examples of when tax 
liabilities are considered liabilities assumed by new target.
    (2) Time and amount of liabilities. The time for taking into 
account liabilities of old target in determining AGUB and the amount of 
the liabilities taken into account is determined as if new target had 
acquired its assets from an unrelated person for consideration that 
included the assumption of, or taking subject to, the liabilities. For 
example, an increase or decrease in a liability that does not affect 
the amount of new target's basis arising from the assumption of, or 
taking subject to, the liability is not taken into account in 
redetermining AGUB.
    (3) Interaction with deemed sale gain. See Sec. 1.338-4(d)(3).
    (f) Adjustments by the Internal Revenue Service. In connection with 
the examination of a return, the District Director may increase (or 
decrease) AGUB under the authority of section 338(b)(2) and allocate 
such amounts to target's assets under the authority of section 
338(b)(5) so that AGUB and the basis of target's assets properly 
reflect the cost to the purchasing corporation of its interest in 
target's assets. Such items may include distributions from target to 
the purchasing corporation, capital contributions from the purchasing 
corporation to target during the 12-month acquisition period, or 
acquisitions of target stock by the purchasing corporation after the 
acquisition date from minority shareholders.
    (g) Examples. The following examples illustrate this section. For 
purposes of the examples in this paragraph (g), T has no liabilities 
other than the tax liability for the deemed sale gain, T shareholders 
incur no costs in selling the T stock, and P incurs no costs in 
acquiring the T stock. The examples are as follows:

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

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

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

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

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

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

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

    Par. 5. Sections 1.338-6 and 1.338-7 are added to read as follows:


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

    (a) Scope--(1) In general. This section prescribes rules for 
allocating ADSP and AGUB among the acquisition date assets of a target 
for which a section 338 election is made.
    (2) Fair market value--(i) In general. Generally, the fair market 
value of an asset is its gross fair market value (i.e., fair market 
value determined without regard to mortgages, liens, pledges, or other 
liabilities). However, for purposes of determining the amount of old 
target's deemed sale gain, the fair market value of any property 
subject to a nonrecourse indebtedness will be treated as being not less 
than the amount of such indebtedness. (For purposes of the preceding 
sentence, a liability that was incurred because of the acquisition of 
the property is disregarded to the extent that such liability was not 
taken into account in determining old target's basis in such property.)
    (ii) Transaction costs. Transaction costs are not taken into 
account in allocating ADSP or AGUB to assets in the deemed sale (except 
indirectly through their effect on the total ADSP or AGUB to be 
allocated).
    (iii) Internal Revenue Service authority. In connection with the 
examination of a return, the Internal Revenue Service may challenge the 
taxpayer's determination of the fair market value of any asset by any 
appropriate method and take into account all factors, including any 
lack of adverse tax interests between the parties. For example, in 
certain cases the Internal Revenue Service may make an independent 
showing of the value of goodwill and going concern value as a means of 
calling into question the validity of the taxpayer's valuation of other 
assets.
    (b) General rule for allocating ADSP and AGUB--(1) Reduction in the 
amount of consideration for Class I assets. Both ADSP and AGUB, in the 
respective allocation of each, are first reduced by the amount of Class 
I acquisition date assets. Class I assets are cash and general deposit 
accounts

[[Page 43490]]

(including savings and checking accounts) other than certificates of 
deposit held in banks, savings and loan associations, and other 
depository institutions. If the amount of Class I assets exceeds AGUB, 
new target will immediately realize ordinary income in an amount equal 
to such excess. The amount of ADSP or AGUB remaining after the 
reduction is to be allocated to the remaining acquisition date assets.
    (2) Other assets--(i) In general. Subject to the limitations and 
other rules of paragraph (c) of this section, ADSP and AGUB (as reduced 
by the amount of Class I assets) are allocated among Class II 
acquisition date assets of target in proportion to the fair market 
values of such Class II assets at such time, then among Class III 
assets so held in such proportion, then among Class IV assets so held 
in such proportion, then among Class V assets so held in such 
proportion, then among Class VI assets so held in such proportion, and 
finally to Class VII assets.
    (ii) Class II assets. Class II assets are actively traded personal 
property within the meaning of section 1092(d)(1) and Sec. 1.1092(d)-1 
(determined without regard to section 1092(d)(3)). In addition, Class 
II assets include certificates of deposit and foreign currency even if 
they are not actively traded personal property. Examples of Class II 
assets include U.S. government securities and publicly traded stock.
    (iii) Class III assets. Class III assets are accounts receivable, 
mortgages, and credit card receivables from customers which arise in 
the ordinary course of business.
    (iv) Class IV assets. Class IV assets are stock in trade of the 
taxpayer or other property of a kind which would properly be included 
in the inventory of taxpayer if on hand at the close of the taxable 
year, or property held by the taxpayer primarily for sale to customers 
in the ordinary course of its trade or business.
    (v) Class V assets. Class V assets are all assets other than Class 
I, II, III, IV, VI, and VII assets.
    (vi) Class VI assets. Class VI assets are all section 197 
intangibles, as defined in section 197, except goodwill and going 
concern value.
    (vii) Class VII assets. Class VII assets are goodwill and going 
concern value (whether or not the goodwill or going concern value 
qualifies as a section 197 intangible).
    (3) Other items designated by the Internal Revenue Service. Similar 
items may be added to any class described in this paragraph (b) by 
designation in the Internal Revenue Bulletin by the Internal Revenue 
Service.
    (c) Certain limitations and other rules for allocation to an 
asset--(1) Allocation not to exceed fair market value. The amount of 
ADSP or AGUB allocated to an asset (other than Class VII assets) cannot 
exceed the fair market value of that asset at the beginning of the day 
after the acquisition date.
    (2) Allocation subject to other rules. The amount of ADSP or AGUB 
allocated to an asset is subject to other provisions of the Internal 
Revenue Code or general principles of tax law in the same manner as if 
such asset were transferred to or acquired from an unrelated person in 
a sale or exchange. For example, if the deemed asset sale is a 
transaction described in section 1056(a) (relating to basis limitation 
for player contracts transferred in connection with the sale of a 
franchise), the amount of AGUB allocated to a contract for the services 
of an athlete cannot exceed the limitation imposed by that section. As 
another example, the amount of AGUB allocated to an amortizable section 
197 intangible resulting from an assumption-reinsurance transaction is 
determined under section 197(f)(5).
    (3) Special rule for allocating AGUB when purchasing corporation 
has nonrecently purchased stock--(i) Scope. This paragraph (c)(3) 
applies if at the beginning of the day after the acquisition date--
    (A) The purchasing corporation holds nonrecently purchased stock 
for which a gain recognition election under section 338(b)(3) and 
Sec. 1.338-5(d) is not made; and
    (B) The hypothetical purchase price determined under paragraph 
(c)(3)(ii) of this section exceeds the AGUB determined under 
Sec. 1.338-5(b).
    (ii) Determination of hypothetical purchase price. Hypothetical 
purchase price is the AGUB that would result if a gain recognition 
election were made.
    (iii) Allocation of AGUB. Subject to the limitations in paragraphs 
(c)(1) and (2) of this section, the portion of AGUB (after reduction by 
the amount of Class I assets) to be allocated to each Class II, III, 
IV, V, VI, and VII asset of target held at the beginning of the day 
after the acquisition date is determined by multiplying--
    (A) The amount that would be allocated to such asset under the 
general rules of this section were AGUB equal to the hypothetical 
purchase price; by
    (B) A fraction, the numerator of which is actual AGUB (after 
reduction by the amount of Class I assets) and the denominator of which 
is the hypothetical purchase price (after reduction by the amount of 
Class I assets).
    (4) Liabilities taken into account in determining amount realized 
on subsequent disposition. In determining the amount realized on a 
subsequent sale or other disposition of property deemed purchased by 
new target, the entire amount of any liability taken into account in 
AGUB is considered to be an amount taken into account in determining 
new target's basis in property that secures the liability for purposes 
of applying Sec. 1.1001-2(a). Thus, if a liability is taken into 
account in AGUB, Sec. 1.1001-2(a)(3) does not prevent the amount of 
such liability from being treated as discharged within the meaning of 
Sec. 1.1001-2(a)(4) as a result of new target's sale or disposition of 
the property which secures such liability.
    (d) Examples. The following examples illustrate Secs. 1.338-4, 
1.338-5, and this section:

    Example 1. (i) T owns 90 percent of the outstanding T1 stock. P 
purchases 100 percent of the outstanding T stock for $2,000. There 
are no acquisition costs. P makes a section 338 election for T and, 
as a result, T1 is considered acquired in a qualified stock 
purchase. A section 338 election is made for T1. The grossed-up 
basis of the T stock is $2,000 (i.e., $2,000  x  1/1).
    (ii) The liabilities of T as of the beginning of the day after 
the acquisition date (including the tax liability for the deemed 
sale gain) that would, under general principles of tax law, be 
properly taken into account before the close of new T's first 
taxable year, are as follows:


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

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


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

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

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


[[Page 43491]]

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


Building.......................................................      800
Land...........................................................      200
Investment in T1...............................................      450
                                                                --------
  Total........................................................   $1,450
 

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


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

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


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

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

------------------------------------------------------------------------
                                                                   Fair
        Asset Class                        Asset                  Market
                                                                  Value
------------------------------------------------------------------------
I.........................  Cash...............................     *$50
IV........................  Inventory..........................      200
VI........................  Patent.............................      350
                                                                --------
                                Total..........................     600
------------------------------------------------------------------------
*Amount.

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

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

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


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

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

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

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

    (a) Scope. ADSP and AGUB are redetermined at such time and in such 
amount as an increase or decrease would be required under general 
principles of tax law for the elements of ADSP or AGUB. This section 
provides rules for allocating redetermined ADSP or AGUB when increases 
or decreases with respect to the elements of ADSP or AGUB are required 
after the close of new target's first taxable year. For determining and 
allocating ADSP or AGUB when increases or decreases are required with 
respect to the elements of ADSP or AGUB before the close of new 
target's first taxable year, see Secs. 1.338-4, 1.338-5, and 1.338-6.
    (b) Allocation of redetermined ADSP and AGUB. When ADSP or AGUB is 
redetermined, a new allocation of ADSP or AGUB is made by allocating 
the redetermined ADSP or AGUB amount under the rules of Sec. 1.338-6. 
If the allocation of the redetermined ADSP or AGUB amount under 
Sec. 1.338-6 to a given asset is different from the original allocation 
to it, the difference is added

[[Page 43492]]

to or subtracted from the original allocation to the asset, as 
appropriate. Amounts allocable to an acquisition date asset (or with 
respect to a disposed-of acquisition date asset) are subject to all the 
asset allocation rules (for example, the fair market value limitation 
in Sec. 1.338-6(c)(1)) as if the redetermined ADSP or AGUB were the 
ADSP or AGUB on the acquisition date.
    (c) Special rules for ADSP--(1) Increases or decreases in deemed 
sale gain taxable notwithstanding old target ceases to exist. To the 
extent general principles of tax law would require a seller in an 
actual asset sale to account for events relating to the sale that occur 
after the sale date, target must make such an accounting. Target is not 
precluded from realizing additional deemed sale gain because the target 
is treated as a new corporation after the acquisition date.
    (2) Procedure for transactions in which section 338(h)(10) is not 
elected--(i) Deemed sale gain included in new target's return. If an 
election under section 338(h)(10) is not made, any additional deemed 
sale gain of old target resulting from an increase or decrease in the 
ADSP is included in new target's income tax return for new target's 
taxable year in which the increase or decrease is taken into account. 
For example, if after the acquisition date there is an increase in the 
allocable ADSP of section 1245 property for which the recomputed basis 
(but not the adjusted basis) exceeds the portion of the ADSP allocable 
to that particular asset on the acquisition date, the additional gain 
is treated as ordinary income to the extent it does not exceed such 
excess amount. See paragraph (c)(2)(ii) of this section for the special 
treatment of old target's carryovers and carrybacks. Although included 
in new target's income tax return, the deemed sale gain is separately 
accounted for as an item of old target and may not be offset by income, 
gain, deduction, loss, credit, or other amount of new target. The 
amount of tax on income of old target resulting from an increase or 
decrease in the ADSP is determined as if such deemed sale gain had been 
recognized in old target's taxable year ending at the close of the 
acquisition date.
    (ii) Carryovers and carrybacks--(A) Loss carryovers to new target 
taxable years. A net operating loss or net capital loss of old target 
may be carried forward to a taxable year of new target, under the 
principles of section 172 or 1212, as applicable, but is allowed as a 
deduction only to the extent of any recognized income of old target for 
such taxable year, as described in paragraph (c)(2)(i) of this section. 
For this purpose, however, taxable years of new target are not taken 
into account in applying the limitations in section 172(b)(1) or 
1212(a)(1)(B) (or other similar limitations). In applying sections 
172(b) and 1212(a)(1), only income, gain, loss, deduction, credit, and 
other amounts of old target are taken into account. Thus, if old target 
has an unexpired net operating loss at the close of its taxable year in 
which the deemed asset sale occurred that could be carried forward to a 
subsequent taxable year, such loss may be carried forward until it is 
absorbed by old target's income.
    (B) Loss carrybacks to taxable years of old target. An ordinary 
loss or capital loss accounted for as a separate item of old target 
under paragraph (c)(2)(i) of this section may be carried back to a 
taxable year of old target under the principles of section 172 or 1212, 
as applicable. For this purpose, taxable years of new target are not 
taken into account in applying the limitations in section 172(b) or 
1212(a) (or other similar limitations).
    (C) Credit carryovers and carrybacks. The principles described in 
paragraphs (c)(2)(ii)(A) and (B) of this section apply to carryovers 
and carrybacks of amounts for purposes of determining the amount of a 
credit allowable under part IV, subchapter A, chapter 1 of the Internal 
Revenue Code. Thus, for example, credit carryovers of old target may 
offset only income tax attributable to items described in paragraph 
(c)(2)(i) of this section.
    (3) Procedure for transactions in which section 338(h)(10) is 
elected. If an election under section 338(h)(10) is made, any 
additional deemed sale gain resulting from an increase or decrease in 
the ADSP is accounted for in determining the taxable income (or other 
amount) of the member of the selling consolidated group, the selling 
affiliate, or the S corporation shareholders to which such income, 
loss, or other amount is attributable for the taxable year in which 
such increase or decrease is taken into account.
    (d) Special rules for AGUB--(1) Effect of disposition or 
depreciation of acquisition date assets. If an acquisition date asset 
has been disposed of, depreciated, amortized, or depleted by new target 
before an amount is added to the original allocation to the asset, the 
increased amount otherwise allocable to such asset is taken into 
account under general principles of tax law that apply when part of the 
cost of an asset not previously taken into account in basis is paid or 
incurred after the asset has been disposed of, depreciated, amortized, 
or depleted. A similar rule applies when an amount is subtracted from 
the original allocation to the asset. For purposes of the preceding 
sentence, an asset is considered to have been disposed of to the extent 
that its allocable portion of the decrease in AGUB would reduce its 
basis below zero.
    (2) Section 38 property. Section 1.47-2(c) applies to a reduction 
in basis of section 38 property under this section.
    (e) Examples. The following examples illustrate this section. Any 
amount described in the following examples is exclusive of interest. 
For rules characterizing deferred contingent payments as principal or 
interest, see Secs. 1.483-4, 1.1274-2(g), and 1.1275-4(c). The examples 
are as follows:

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


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

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

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

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

[[Page 43493]]

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

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

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

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

    (ii) On September 30, 2004, P filed a claim against the selling 
shareholders of T in a court of appropriate jurisdiction alleging 
fraud in the sale of the T stock.
    (iii) On January 1, 2007, the former shareholders refund $140 of 
the purchase price to P in a settlement of the lawsuit. Assume that, 
under general principles of tax law, both the seller and the buyer 
properly take into account such refund when paid. Assume also that 
the refund has no effect on the tax liability for the deemed sale 
gain. This refund results in a decrease of T's ADSP and AGUB of 
$140, from $500 to $360.
    (iv) The redetermined ADSP and AGUB of $360 is allocated among 
T's acquisition date assets. Because ADSP and AGUB do not exceed the 
fair market value of the Class V assets, the ADSP and AGUB amounts 
are allocated to the Class V assets in proportion to their fair 
market values at the beginning of the day after the acquisition 
date. Thus, $135 ($150 ($360/($150 + $250))) is allocated to the 
machinery and $225 ($250 ($360/($150 + $250))) is allocated to the 
land. Accordingly, the basis of the machinery is reduced by $15 
($150 original allocation $135 redetermined allocation) and the 
basis of the land is reduced by $25 ($250 original allocation -$225 
redetermined allocation). No amount is allocated to the Class VII 
assets. Accordingly, the basis of the goodwill and going concern 
value is reduced by $100 ($100 original allocation -$0 redetermined 
allocation).
    (v) Assume that, as a result of deductions under section 168, 
the adjusted basis of the machinery immediately before the decrease 
in AGUB is zero. The machinery is treated as if it were disposed of 
before the decrease is taken into account. In 2007, T recognizes 
income of $15, the character of which is determined under the 
principles of Arrowsmith v. Commissioner, 344 U.S. 6 (1952), and the 
tax benefit rule. No adjustment to the basis of T's assets is made 
for any tax paid on this amount. Assume also that, as a result of 
amortization deductions, the adjusted basis of the goodwill and 
going concern value immediately before the decrease in AGUB is $40. 
A similar adjustment to income is made in 2007 with respect to the 
$60 of previously amortized goodwill and going concern value.
    (vi) In summary, the basis of T's acquisition date assets, as of 
January 1, 2007, is as follows:

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

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

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

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

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

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

[[Page 43494]]



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

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

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

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

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

    (ii) T has no liabilities. The AGUB is $700. In calculating 
ADSP, assume that, under Sec. 1.1001-1, the current amount realized 
attributable to the contingent consideration is $200. ADSP is 
therefore $900 ($700 cash plus $200).
    (iii) (A) The AGUB of $700 is ratably allocated among T's Class 
V acquisition date assets in proportion to their fair market values 
as follows:

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

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

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

    (B) The remaining ADSP, $100, is allocated to goodwill and going 
concern value (Class VII).
    (v) P and T file a consolidated return for 2001 and each 
following year with P as the common parent of the affiliated group.
    (vi) In 2004, a contingent amount of $120 is paid by P. Assume 
that, under general principles of tax law, the payment is properly 
taken into account by P at the time made. In 2004, there is an 
increase in T's AGUB of $120. The amount of the increase allocated 
to each acquisition date asset is determined as follows:

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


[[Page 43495]]

    Par. 6. Section 1.338 10 is added to read as follows:


Sec. 1.338-10  Filing of returns.

    (a) Returns including tax liability from deemed asset sale--(1) In 
general. Except as provided in paragraphs (a)(2) and (3) of this 
section, any deemed sale gain is reported on the final return of old 
target filed for old target's taxable year that ends at the close of 
the acquisition date. If old target is the common parent of an 
affiliated group, the final return may be a consolidated return (any 
such consolidated return must also include any deemed sale gain of any 
members of the consolidated group that are acquired by the purchasing 
corporation on the same acquisition date as old target).
    (2) Old target's final taxable year otherwise included in 
consolidated return of selling group--(i) General rule. If the selling 
group files a consolidated return for the period that includes the 
acquisition date, old target is disaffiliated from that group 
immediately before the deemed asset sale and must file a deemed sale 
return separate from the group that includes only the deemed sale gain 
and the carryover items specified in paragraph (a)(2)(iii) of this 
section. The deemed asset sale occurs at the close of the acquisition 
date and is the last transaction of old target. Any transactions of old 
target occurring on the acquisition date other than the deemed asset 
sale are included in the selling group's consolidated return. A deemed 
sale return includes a combined deemed sale return as defined in 
paragraph (a)(4) of this section.
    (ii) Separate taxable year. The deemed asset sale included in the 
deemed sale return under this paragraph (a)(2) occurs in a separate 
taxable year, except that old target's taxable year of the sale and the 
consolidated year of the selling group that includes the acquisition 
date are treated as the same year for purposes of determining the 
number of years in a carryover or carryback period.
    (iii) Carryover and carryback of tax attributes. Target's 
attributes may be carried over to, and carried back from, the deemed 
sale return under the rules applicable to a corporation that ceases to 
be a member of a consolidated group.
    (iv) Old target is a component member of purchasing corporation's 
controlled group. For purposes of its deemed sale return, target is a 
component member of the controlled group of corporations including the 
purchasing corporation unless target is treated as an excluded member 
under section 1563(b)(2).
    (3) Old target is an S corporation. If target is an S corporation 
for the period that ends on the day before the acquisition date, old 
target must file a deemed sale return as a C corporation. For this 
purpose, the principles of paragraph (a)(2) of this section apply. This 
paragraph (a)(3) does not apply if an election under section 338(h)(10) 
is made for the S corporation.
    (4) Combined deemed sale return--(i) General rule. Under section 
338(h)(15), a combined deemed sale return (combined return) may be 
filed for all targets from a single selling consolidated group (as 
defined in Sec. 1.338(h)(10)-1(b)(3)) that are acquired by the 
purchasing corporation on the same acquisition date and that otherwise 
would be required to file separate deemed sale returns. The combined 
return must include all such targets. For example, T and T1 may be 
included in a combined return if--
    (A) T and T1 are directly owned subsidiaries of S;
    (B) S is the common parent of a consolidated group; and
    (C) P makes qualified stock purchases of T and T1 on the same 
acquisition date.
    (ii) Gain and loss offsets. Gains and losses recognized on the 
deemed asset sales by targets included in a combined return are treated 
as the gains and losses of a single target. In addition, loss 
carryovers of a target that were not subject to the separate return 
limitation year restrictions (SRLY restrictions) of the consolidated 
return regulations while that target was a member of the selling 
consolidated group may be applied without limitation to the gains of 
other targets included in the combined return. If, however, a target 
has loss carryovers that were subject to the SRLY restrictions while 
that target was a member of the selling consolidated group, the use of 
those losses in the combined return continues to be subject to those 
restrictions, applied in the same manner as if the combined return were 
a consolidated return. A similar rule applies, when appropriate, to 
other tax attributes.
    (iii) Procedure for filing a combined return. A combined return is 
made by filing a single corporation income tax return in lieu of 
separate deemed sale returns for all targets required to be included in 
the combined return. The combined return reflects the deemed asset 
sales of all targets required to be included in the combined return. If 
the targets included in the combined return constitute a single 
affiliated group within the meaning of section 1504(a), the income tax 
return is signed by an officer of the common parent of that group. 
Otherwise, the return must be signed by an officer of each target 
included in the combined return. Rules similar to the rules in 
Sec. 1.1502-75(j) apply for purposes of preparing the combined return. 
The combined return must include an attachment prominently identified 
as an ELECTION TO FILE A COMBINED RETURN UNDER SECTION 338(h)(15). The 
attachment must--
    (A) Contain the name, address, and employer identification number 
of each target required to be included in the combined return;
    (B) Contain the following declaration (or a substantially similar 
declaration): EACH TARGET IDENTIFIED IN THIS ELECTION TO FILE A 
COMBINED RETURN CONSENTS TO THE FILING OF A COMBINED RETURN;
    (C) For each target, be signed by a person who states under 
penalties of perjury that he or she is authorized to act on behalf of 
such target.
    (iv) Consequences of filing a combined return. Each target included 
in a combined return is severally liable for any tax associated with 
the combined return. See Sec. 1.338-1(b)(3).
    (5) Deemed sale excluded from purchasing corporation's consolidated 
return. Old target may not be considered a member of any affiliated 
group that includes the purchasing corporation with respect to its 
deemed asset sale.
    (6) Due date for old target's final return--(i) General rule. Old 
target's final return is generally due on the 15th day of the third 
calendar month following the month in which the acquisition date 
occurs. See section 6072 (time for filing income tax returns).
    (ii) Application of Sec. 1.1502-76(c)--(A) In general. Section 
1.1502-76(c) applies to old target's final return if old target was a 
member of a selling group that did not file consolidated returns for 
the taxable year of the common parent that precedes the year that 
includes old target's acquisition date. If the selling group has not 
filed a consolidated return that includes old target's taxable period 
that ends on the acquisition date, target may, on or before the final 
return due date (including extensions), either--
    (1) File a deemed sale return on the assumption that the selling 
group will file the consolidated return; or
    (2) File a return for so much of old target's taxable period as 
ends at the close of the acquisition date on the assumption that the 
consolidated return will not be filed.
    (B) Deemed extension. For purposes of applying Sec. 1.1502-
76(c)(2), an extension of time to file old target's final return is 
considered to be in effect until

[[Page 43496]]

the last date for making the election under section 338.
    (C) Erroneous filing of deemed sale return. If, under this 
paragraph (a)(6)(ii), target files a deemed sale return but the selling 
group does not file a consolidated return, target must file a 
substituted return for old target not later than the due date 
(including extensions) for the return of the common parent with which 
old target would have been included in the consolidated return. The 
substituted return is for so much of old target's taxable year as ends 
at the close of the acquisition date. Under Sec. 1.1502-76(c)(2), the 
deemed sale return is not considered a return for purposes of section 
6011 (relating to the general requirement of filing a return) if a 
substituted return must be filed.
    (D) Erroneous filing of return for regular tax year. If, under this 
paragraph (a)(6)(ii), target files a return for so much of old target's 
regular taxable year as ends at the close of the acquisition date but 
the selling group files a consolidated return, target must file an 
amended return for old target not later than the due date (including 
extensions) for the selling group's consolidated return. (The amended 
return is a deemed sale return.)
    (E) Last date for payment of tax. If either a substituted or 
amended final return of old target is filed under this paragraph 
(a)(6)(ii), the last date prescribed for payment of tax is the final 
return due date (as defined in paragraph (a)(6)(i) of this section).
    (7) Examples. The following examples illustrate this paragraph (a):

    Example 1. (i) S is the common parent of a consolidated group 
that includes T. The S group files calendar year consolidated 
returns. At the close of June 30 of Year 1, P makes a qualified 
stock purchase of T from S. P makes a section 338 election for T, 
and T's deemed asset sale occurs as of the close of T's acquisition 
date (June 30).
    (ii) T is considered disaffiliated for purposes of reporting the 
deemed sale gain. Accordingly, T is included in the S group's 
consolidated return through T's acquisition date except that the tax 
liability for the deemed sale gain is reported in a separate deemed 
sale return of T. Provided that T is not treated as an excluded 
member under section 1563(b)(2), T is a component member of P's 
controlled group for the taxable year of the deemed asset sale, and 
the taxable income bracket amounts available in calculating tax on 
the deemed sale return must be limited accordingly.
    (iii) If P purchased the stock of T at 10 a.m. on June 30 of 
Year 1, the results would be the same. See paragraph (a)(2)(i) of 
this section.
    Example 2. The facts are the same as in Example 1, except that 
the S group does not file consolidated returns. T must file a 
separate return for its taxable year ending on June 30 of Year 1, 
which return includes the deemed asset sale.

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

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


Secs. 1.338(b)-1, 1.338(b)-2T, and 1.338(b)-3T  [Removed]

    Par. 7. Sections 1.338(b)-1, 1.338(b)-2T, and 1.338(b)-3T, are 
removed.
    Par. 8. Section 1.338(h)(10)-1 is revised to read as follows.


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

    (a) Scope. This section prescribes rules for qualification for a 
section 338(h)(10) election and for making a section 338(h)(10) 
election. This section also prescribes the consequences of such 
election. The rules of this section are in addition to the rules of 
Secs. 1.338-0 through 1.338-10 and 1.338(i)-1 and, in appropriate 
cases, apply instead of the rules of Secs. 1.338-0 through 1.338-10 and 
1.338(i)-1.
    (b) Definitions--(1) Consolidated target. A consolidated target is 
a target that is a member of a consolidated group within the meaning of 
Sec. 1.1502-1(h) on the acquisition date and is not the common parent 
of the group on that date.
    (2) Selling consolidated group. A selling consolidated group is the 
consolidated group of which the consolidated target is a member on the 
acquisition date.
    (3) Selling affiliate; affiliated target. A selling affiliate is a 
domestic corporation that owns on the acquisition date an amount of 
stock in a domestic target, which amount of stock is

[[Page 43497]]

described in section 1504(a)(2), and does not join in filing a 
consolidated return with the target. In such case, the target is an 
affiliated target.
    (4) S corporation target. An S corporation target is a target that 
is an S corporation immediately before the acquisition date.
    (5) S corporation shareholders. S corporation shareholders are the 
S corporation target's shareholders. Unless otherwise indicated, a 
reference to S corporation shareholders refers both to S corporation 
shareholders who do and those who do not sell their target stock.
    (6) Liquidation. Any reference in this section to a liquidation is 
treated as a reference to the transfer described in paragraph (d)(4) of 
this section notwithstanding its ultimate characterization for Federal 
income tax purposes.
    (c) Section 338(h)(10) election--(1) In general. A section 
338(h)(10) election may be made for T if P acquires stock meeting the 
requirements of section 1504(a)(2) from a selling consolidated group, a 
selling affiliate, or the S corporation shareholders in a qualified 
stock purchase.
    (2) Simultaneous joint election requirement. A section 338(h)(10) 
election is made jointly by P and the selling consolidated group (or 
the selling affiliate or the S corporation shareholders) on Form 8023 
in accordance with the instructions to the form. S corporation 
shareholders who do not sell their stock must also consent to the 
election. The section 338(h)(10) election must be made not later than 
the 15th day of the 9th month beginning after the month in which the 
acquisition date occurs.
    (3) Irrevocability. A section 338(h)(10) election is irrevocable. 
If a section 338(h)(10) election is made for T, a section 338 election 
is deemed made for T.
    (4) Effect of invalid election. If a section 338(h)(10) election 
for T is not valid, the section 338 election for T is also not valid.
    (d) Certain consequences of section 338(h)(10) election. For 
purposes of subtitle A of the Internal Revenue Code (except as provided 
in Sec. 1.338-1(b)(2)), the consequences to the parties of making a 
section 338(h)(10) election for T are as follows:
    (1) P. P is automatically deemed to have made a gain recognition 
election for its nonrecently purchased T stock, if any. The effect of a 
gain recognition election includes a taxable deemed sale by P on the 
acquisition date of any nonrecently purchased target stock. See 
Sec. 1.338-5(d).
    (2) New T. The AGUB for new T's assets is determined under 
Sec. 1.338-5 and is allocated among the acquisition date assets under 
Secs. 1.338-6 and 1.338-7. Notwithstanding paragraph (d)(4) of this 
section (deemed liquidation of old T), new T remains liable for the tax 
liabilities of old T (including the tax liability for the deemed sale 
gain). For example, new T remains liable for the tax liabilities of the 
members of any consolidated group that are attributable to taxable 
years in which those corporations and old T joined in the same 
consolidated return. See Sec. 1.1502-6(a).
    (3) Old T--deemed sale--(i) In general. Old T is treated as 
transferring all of its assets to an unrelated person in exchange for 
consideration that includes the assumption of or taking subject to 
liabilities in a single transaction at the close of the acquisition 
date (but before the deemed liquidation). See Sec. 1.338-1(a) regarding 
the tax characterization of the deemed asset sale. ADSP for old T is 
determined under Sec. 1.338-4 and allocated among the acquisition date 
assets under Secs. 1.338-6 and 1.338-7. Old T realizes the deemed sale 
gain from the deemed asset sale before the close of the acquisition 
date while old T is a member of the selling consolidated group (or 
owned by the selling affiliate or owned by the S corporation 
shareholders). If T is an affiliated target, or an S corporation 
target, the principles of Secs. 1.338-2(c)(10) and 1.338-10(a)(1), (5), 
and (6)(i) apply to the return on which the deemed sale gain is 
reported. When T is an S corporation target, T's S election continues 
in effect through the close of the acquisition date (including the time 
of the deemed asset sale and the deemed liquidation) notwithstanding 
section 1362(d)(2)(B). Also, when T is an S corporation target, any 
direct and indirect subsidiaries of T which T has elected to treat as 
qualified subchapter S subsidiaries under section 1361(b)(3) remain 
qualified subchapter S subsidiaries through the close of the 
acquisition date. No similar rule applies when a qualified subchapter S 
subsidiary, as opposed to the S corporation that is its owner, is the 
target the stock of which is actually purchased.
    (ii) Tiered targets. In the case of parent-subsidiary chains of 
corporations making elections under section 338(h)(10), the deemed 
asset sale of a parent corporation is considered to precede that of its 
subsidiary. See Sec. 1.338-3(4)(i).
    (4) Old T and selling consolidated group, selling affiliate, or S 
corporation shareholders--deemed liquidation; tax characterization--(i) 
In general. Old T is treated as if, before the close of the acquisition 
date, after the deemed asset sale in paragraph (d)(3) of this section, 
and while old T is a member of the selling consolidated group (or owned 
by the selling affiliate or owned by the S corporation shareholders), 
it transferred all of its assets to members of the selling consolidated 
group, the selling affiliate, or S corporation shareholders and ceased 
to exist. The transfer from old T is characterized for Federal income 
tax purposes in the same manner as if the parties had actually engaged 
in the transactions deemed to occur because of this section and taking 
into account other transactions that actually occurred or are deemed to 
occur. For example, the transfer may be treated as a distribution in 
pursuance of a plan of reorganization, a distribution in complete 
cancellation or redemption of all its stock, one of a series of 
distributions in complete cancellation or redemption of all its stock 
in accordance with a plan of liquidation, or part of a circular flow of 
cash. In most cases, the transfer will be treated as a distribution in 
complete liquidation to which section 336 or 337 applies.
    (ii) Tiered targets. In the case of parent-subsidiary chains of 
corporations making elections under section 338(h)(10), the deemed 
liquidation of a subsidiary corporation is considered to precede the 
deemed liquidation of its parent.
    (5) Selling consolidated group, selling affiliate, or S corporation 
shareholders--(i) In general. If T is an S corporation target, S 
corporation shareholders (whether or not they sell their stock) take 
their pro rata share of the deemed sale gain into account under section 
1366 and increase or decrease their basis in T stock under section 
1367. Members of the selling consolidated group, the selling affiliate, 
or S corporation shareholders are treated as if, after the deemed asset 
sale in paragraph (d)(3) of this section and before the close of the 
acquisition date, they received the assets transferred by old T in the 
transaction described in paragraph (d)(4)(i) of this section. In most 
cases, the transfer will be treated as a distribution in complete 
liquidation to which section 331 or 332 applies.
    (ii) Basis and holding period of T stock not acquired. A member of 
the selling consolidated group (or the selling affiliate or an S 
corporation shareholder) retaining T stock is treated as acquiring the 
stock so retained on the day after the acquisition date for its fair 
market value. The holding period for the retained stock starts on the 
day after the acquisition date. For purposes of this

[[Page 43498]]

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


    Example 1. (i) S1 owns all of the T stock and T owns all of the 
stock of T1 and T2. S1 is the common parent of a consolidated group 
that includes T, T1, and T2. P makes a qualified stock purchase of 
all of the T stock from S1. S1 joins with P in making a section 
338(h)(10) election for T and for the deemed purchase of T1. A 
section 338 election is not made for T2.
    (ii) S1 does not recognize gain or loss on the sale of the T 
stock and T does not recognize gain or loss on the sale of the T1 
stock because section 338(h)(10) elections are made for T and T1. 
Thus, for example, gain or loss realized on the sale of the T or T1 
stock is not taken into account in earnings and profits. However, 
because a section 338 election is not made for T2, T must recognize 
any gain or loss realized on the deemed sale of the T2 stock. See 
Sec. 1.338-4(h).
    (iii) The results would be the same if S1, T, T1, and T2 are not 
members of any consolidated group, because S1 and T are selling 
affiliates.
    Example 2. (i) S and T are solvent corporations. S owns all of 
the outstanding stock of T. S and P agree to undertake the following 
transaction: T will distribute half its assets to S, and S will 
assume half of T's liabilities. Then, P will purchase the stock of T 
from S. S and P will jointly make a section 338(h)(10) election with 
respect to the sale of T. The corporations then complete the 
transaction as agreed.
    (ii) Under section 338(a), the assets present in T at the close 
of the acquisition date are deemed sold by old T to new T. Under 
paragraph (d)(4) of this section, the transactions described in 
paragraph (d) of this section are treated in the same manner as if 
they had actually occurred. Because S and P had agreed that, after 
T's actual distribution to S of part of its assets, S would sell T 
to P pursuant to an election under section 338(h)(10), and because 
paragraph (d)(4) of this section deems T subsequently to have 
transferred all its assets to its shareholder, T is deemed to have 
adopted a plan of complete liquidation under section 332. T's actual 
transfer of assets to S is treated as a distribution pursuant to 
that plan of complete liquidation.
    Example 3. (i) S1 owns all of the outstanding stock of both T 
and S2. All three are corporations. S1 and P agree to undertake the 
following transaction. T will transfer substantially all of its 
assets and liabilities to S2, with S2 issuing no stock in exchange 
therefor, and retaining its other assets and liabilities. Then, P 
will purchase the stock of T from S1. S1 and P will jointly make a 
section 338(h)(10) election with respect to the sale of T. The 
corporations then complete the transaction as agreed.
    (ii) Under section 338(a), the assets present in T at the close 
of the acquisition date are deemed sold by old T to new T. Under 
paragraph (d)(4) of this section, the transactions described in this 
section are treated in the same manner as if they had actually 
occurred. Because old T transferred substantially all of its assets 
to S2, and is deemed to have distributed all its remaining assets 
and gone out of existence, the transfer of assets to S2, taking into 
account the related transfers, deemed and actual, qualifies as a

[[Page 43499]]

reorganization under section 368(a)(1)(D). Section 361(c)(1) and not 
section 332 applies to T's deemed liquidation.
    Example 4. (i) T owns two assets: an actively traded security 
(Class II) with a fair market value of $100 and an adjusted basis of 
$100, and inventory (Class IV) with a fair market value of $100 and 
an adjusted basis of $100. T has no liabilities. S is negotiating to 
sell all the stock in T to P for $100 cash and contingent 
consideration. Assume that under generally applicable tax accounting 
rules, P's adjusted basis in the T stock immediately after the 
purchase would be $100, because the contingent consideration is not 
taken into account. Thus, under the rules of Sec. 1.338-5, AGUB 
would be $100. Under the allocation rules of Sec. 1.338-6, the 
entire $100 would be allocated to the Class II asset, the actively 
traded security, and no amount would be allocated to the inventory. 
P, however, plans immediately to cause T to sell the inventory, but 
not the actively traded security, so it requests that, prior to the 
stock sale, S cause T to create a new subsidiary, Newco, and 
contribute the actively traded security to the capital of Newco. 
Because the stock in Newco, which would not be actively traded, is a 
Class V asset, under the rules of Sec. 1.338-6 $100 of AGUB would be 
allocated to the inventory and no amount of AGUB would be allocated 
to the Newco stock. Newco's own AGUB, $0 under the rules of 
Sec. 1.338-5, would be allocated to the actively traded security. 
When P subsequently causes T to sell the inventory, T would realize 
no gain or loss instead of realizing gain of $100.
    (ii) Assume that, if the T stock had not itself been sold but T 
had instead sold both its inventory and the Newco stock to P, T 
would for tax purposes be deemed instead to have sold both its 
inventory and actively traded security directly to P, with P deemed 
then to have created Newco and contributed the actively traded 
security to the capital of Newco. Section 338, if elected, generally 
recharacterizes a stock sale as a deemed sale of assets. The tax 
results of the deemed sale of assets should, where possible, be like 
those of an actual asset sale. Hence, the deemed sale of assets 
under section 338(h)(10) should be treated as one of the inventory 
and actively traded security themselves, not of the inventory and 
Newco stock. That is the substance of the transaction. The anti-
abuse rule of Sec. 1.338-1(c) does not apply, because the substance 
of the deemed sale of assets is a sale of the inventory and the 
actively traded security themselves, not of the inventory and the 
Newco stock. Otherwise, the anti-abuse rule might apply.
    Example 5. (i) T, a member of a selling consolidated group, has 
only one class of stock, all of which is owned by S1. On March 1 of 
Year 2, S1 sells its T stock to P for $80,000, and joins with P in 
making a section 338(h)(10) election for T. There are no selling 
costs or acquisition costs. On March 1 of Year 2, T owns land with a 
$50,000 basis and $75,000 fair market value and equipment with a 
$30,000 adjusted basis, $70,000 recomputed basis, and $60,000 fair 
market value. T also has a $40,000 liability. S1 pays old T's 
allocable share of the selling group's consolidated tax liability 
for Year 2 including the tax liability for the deemed sale gain (a 
total of $13,600).
    (ii) ADSP of $120,000 ($80,000 + $40,000 + 0) is allocated to 
each asset as follows:

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

    (iii) Under paragraph (d)(3) of this section, old T has gain on 
the deemed sale of $40,000 (consisting of $16,667 of capital gain 
and $23,333 of ordinary income).
    (iv) Under paragraph (d)(5)(iii) of this section, S1 recognizes 
no gain or loss upon its sale of the old T stock to P. S1 also 
recognizes no gain or loss upon the deemed liquidation of T. See 
paragraph (d)(4) of this section and section 332.
    (v) P's basis in new T stock is P's cost for the stock, $80,000. 
See section 1012.
    (vi) Under Sec. 1.338-5, the AGUB for new T is $120,000, i.e., 
P's cost for the old T stock ($80,000) plus T's liability ($40,000). 
This AGUB is allocated as basis among the new T assets under 
Secs. 1.338-6 and 1.338-7.
    Example 6. (i) The facts are the same as in Example 5, except 
that S1 sells 80 percent of the old T stock to P for $64,000, rather 
than 100 percent of the old T stock for $80,000.
    (ii) The consequences to P, T, and S1 are the same as in Example 
5, except that:
    (A) P's basis for its 80-percent interest in the new T stock is 
P's $64,000 cost for the stock. See section 1012.
    (B) Under Sec. 1.338-5, the AGUB for new T is $120,000 (i.e., 
$64,000/.8 + $40,000 + $0).
    (C) Under paragraph (d)(4) of this section, S1 recognizes no 
gain or loss with respect to the retained stock in T. See section 
332.
    (D) Under paragraph (d)(5)(ii) of this section, the basis of the 
T stock retained by S1 is $16,000 (i.e., $120,000 -$40,000 (the ADSP 
amount for the old T assets over the sum of new T's liabilities 
immediately after the acquisition date)  x .20 (the proportion of T 
stock retained by S1)).
    Example 7. (i) The facts are the same as in Example 6, except 
that K, a shareholder unrelated to T or P, owns the 20 percent of 
the T stock that is not acquired by P in the qualified stock 
purchase. K's basis in its T stock is $5,000.
    (ii) The consequences to P, T, and S1 are the same as in Example 
6.
    (iii) Under paragraph (d)(6)(iii) of this section, K recognizes 
no gain or loss, and K's basis in its T stock remains at $5,000.
    Example 8. (i) The facts are the same as in Example 5, except 
that the equipment is held by T1, a wholly-owned subsidiary of T, 
and a section 338(h)(10) election is also made for T1. The T1 stock 
has a fair market value of $60,000. T1 has no assets other than the 
equipment and no liabilities. S1 pays old T's and old T1's allocable 
shares of the selling group's consolidated tax liability for Year 2 
including the tax liability for T and T1's deemed sale gain.
    (ii) ADSP for T is $120,000, allocated $66,667 to the land and 
$53,333 to the stock. Old T's deemed sale gain is $16,667 (the 
capital gain on its deemed sale of the land). Under paragraph 
(d)(5)(iii) of this section, old T does not recognize gain or loss 
on its deemed sale of the T1 stock. See section 332.
    (iii) ADSP for T1 is $53,333 (i.e., $53,333 + $0 + $0). On the 
deemed sale of the equipment, T1 recognizes ordinary income of 
$23,333.
    (iv) Under paragraph (d)(5)(iii) of this section, S1 does not 
recognize gain or loss upon its sale of the old T stock to P.
    Example 9. (i) The facts are the same as in Example 8, except 
that P already owns 20 percent of the T stock, which is nonrecently 
purchased stock with a basis of $6,000, and that P purchases the 
remaining 80 percent of the T stock from S1 for $64,000.
    (ii) The results are the same as in Example 8, except that under 
paragraph (d)(1) of this section and Sec. 1.338-5(d), P is deemed to 
have made a gain recognition election for its nonrecently purchased 
T stock. As a result, P recognizes gain of $10,000 and its basis in 
the nonrecently purchased T stock is increased from $6,000 to 
$16,000. P's basis in all the T stock is $80,000 (i.e., $64,000 + 
$16,000). The computations are as follows:
    (A) P's grossed-up basis for the recently purchased T stock is 
$64,000 (i.e., $64,000 (the basis of the recently purchased T stock) 
 x (1 .2)/(.8) (the fraction in section 338(b)(4))).
    (B) P's basis amount for the nonrecently purchased T stock is 
$16,000 (i.e., $64,000 (the grossed-up basis in the recently 
purchased T stock)  x (.2)/(1.0-.2) (the fraction in section 
338(b)(3)(B))).
    (C) The gain recognized on the nonrecently purchased stock is 
$10,000 (i.e., $16,000 -$6,000).
    Example 10. (i) T is an S corporation whose sole class of stock 
is owned 40 percent each by A and B and 20 percent by C. A and B 
each has an adjusted basis of $10,000 in the stock. C has an 
adjusted basis of $5,000 in the stock. A, B, and C hold no 
installment obligations to which section 453A applies. On March 1 of 
Year 1, A sells its stock to P for $40,000 in cash and B sells its 
stock to P for a $25,000 note issued by P and real estate having a 
fair market value of $15,000. The $25,000 note, due in full in Year 
7, is not publicly traded and bears adequate stated interest. A and 
B have no selling expenses.

[[Page 43500]]

T's sole asset is real estate, which has a value of $110,000 and an 
adjusted basis of $35,000. Also, T's real estate is encumbered by 
long-outstanding purchase-money indebtedness of $10,000. The real 
estate does not have built-in gain subject to section 1374. A, B, 
and C join with P in making a section 338(h)(10) election for T.
    (ii) Solely for purposes of application of sections 453, 453A, 
and 453B, old T is considered in its deemed asset sale to receive 
back from new T the $25,000 note (considered issued by new T) and 
$75,000 of cash (total consideration of $80,000 paid for all the 
stock sold, which is then divided by .80 in the grossing-up, with 
the resulting figure of $100,000 then reduced by the amount of the 
installment note). Absent an election under section 453(d), gain is 
reported by old T under the installment method.
    (iii) In applying the installment method to old T's deemed asset 
sale, the contract price for old T's assets deemed sold is $100,000, 
the $110,000 selling price reduced by the indebtedness of $10,000 to 
which the assets are subject. (The $110,000 selling price is itself 
the sum of the $80,000 grossed-up in paragraph (ii) above to 
$100,000 and the $10,000 liability.) Gross profit is $75,000 
($110,000 selling price - old T's basis of $35,000). Old T's gross 
profit ratio is 0.75 (gross profit of $75,000  $100,000 
contract price). Thus, $56,250 (0.75  x  the $75,000 cash old T is 
deemed to receive in Year 1) is Year 1 gain attributable to the 
sale, and $18,750 ($75,000 - $56,250) is recovery of basis.
    (iv) In its liquidation, old T is deemed to distribute the 
$25,000 note to B, since B actually sold the stock partly for that 
consideration. To the extent of the remaining liquidating 
distribution to B, it is deemed to receive, along with A and C, the 
balance of old T's liquidating assets in the form of cash. Under 
section 453(h), B, unless it makes an election under section 453(d), 
is not required to treat the receipt of the note as a payment for 
the T stock; P's payment of the $25,000 note in Year 7 to B is a 
payment for the T stock. Because section 453(h) applies to B, old 
T's deemed liquidating distribution of the note is, under section 
453B(h), not treated as a taxable disposition by old T.
    (v) Under section 1366, A reports 40 percent, or $22,500, of old 
T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases A's $10,000 adjusted basis in the T stock to $32,500. 
Next, in old T's deemed liquidation, A is considered to receive 
$40,000 for its old T shares, causing it to recognize an additional 
$7,500 gain in Year 1.
    (vi) Under section 1366, B reports 40 percent, or $22,500, of 
old T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases B's $10,000 adjusted basis in its T stock to $32,500. 
Next, in old T's deemed liquidation, B is considered to receive the 
$25,000 note and $15,000 of other consideration. Applying section 
453, including section 453(h), to the deemed liquidation, B's 
selling price and contract price are both $40,000. Gross profit is 
$7,500 ($40,000 selling price - B's basis of $32,500). B's gross 
profit ratio is 0.1875 (gross profit of $7,500  $40,000 
contract price). Thus, $2,812.50 (0.1875 $15,000) is Year 1 gain 
attributable to the deemed liquidation. In Year 7, when the $25,000 
note is paid, B has $4,687.50 (0.1875  x  $25,000) of additional 
gain.
    (vii) Under section 1366, C reports 20 percent, or $11,250, of 
old T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases C's $5,000 adjusted basis in its T stock to $16,250. Next, 
in old T's deemed liquidation, C is considered to receive $20,000 
for its old T shares, causing it to recognize an additional $3,750 
gain in Year 1. Finally, under paragraph (d)(5)(ii) of this section, 
C is considered to acquire its stock in T on the day after the 
acquisition date for $20,000 (fair market value=grossed-up amount 
realized of $100,000  x  20%). C's holding period in the stock 
deemed received in new T begins at that time.

    (f) Inapplicability of provisions. The provisions of section 6043, 
Sec. 1.331-1(d), and Sec. 1.332-6 (relating to information returns and 
recordkeeping requirements for corporate liquidations) do not apply to 
the deemed liquidation of old T under paragraph (d)(4) of this section.
    (g) Required information. The Commissioner may exercise the 
authority granted in section 338(h)(10)(C)(iii) to require provision of 
any information deemed necessary to carry out the provisions of section 
338(h)(10) by requiring submission of information on any tax reporting 
form.
    Par. 9. Section 1.338(i)-1 is revised to read as follows:


Sec. 1.338(i)-1  Effective dates.

    The provisions of Secs. 1.338-0 through 1.338-10 and 1.338(h)(10)-1 
apply to any qualified stock purchase occurring after the date that 
final regulations are published in the Federal Register. For rules 
applicable to qualified stock purchases before the date that final 
regulations are published in the Federal Register, see Secs. 1.338-0 
through 1.338-5, 1.338(b)-1, 1.338(b)-2T, 1.338(b)-3T, 1.338(h)(10)-1, 
and 1.338(i)-1 as contained in 26 CFR part 1 revised April 1, 1999.
    Par. 10. Section 1.1060-1 is added to read as follows:


Sec. 1.1060-1  Special allocation rules for certain asset acquisitions.

    (a) Scope--(1) In general. This section prescribes rules relating 
to the requirements of section 1060, which, in the case of an 
applicable asset acquisition, requires the transferor (the seller) and 
the transferee (the purchaser) each to allocate the consideration paid 
or received in the transaction among the assets transferred in the same 
manner as amounts are allocated under section 338(b)(5) (relating to 
the allocation of adjusted grossed-up basis among the assets of the 
target corporation when a section 338 election is made). In the case of 
an applicable asset acquisition described in paragraph (b)(1) of this 
section, sellers and purchasers must allocate the consideration under 
the residual method as described in Secs. 1.338-6 and 1.338-7 in order 
to determine, respectively, the amount realized from, and the basis in, 
each of the transferred assets. For rules relating to distributions of 
partnership property or transfers of partnership interests which are 
subject to section 1060(d), see Sec. 1.755-2T.
    (2) Effective date. The provisions of this section apply to any 
asset acquisition occurring after the date that final regulations are 
published in the Federal Register.
    (3) Outline of topics. In order to facilitate the use of this 
section, this paragraph (a)(3) lists the major paragraphs in this 
section as follows:


(a) Scope.
(1) In general.
(2) Effective date.
(3) Outline of topics.
(b) Applicable asset acquisition.
(1) In general.
(2) Assets constituting a trade or business.
(i) In general.
(ii) Goodwill or going concern value.
(iii) Factors indicating goodwill or going concern value.
(3) Examples.
(4) Asymmetrical transfers of assets.
(5) Related transactions.
(6) More than a single trade or business.
(7) Covenant entered into by the seller.
(8) Partial non-recognition exchanges.
(c) Allocation of consideration among assets under the residual 
method.
(1) Consideration.
(2) Allocation of consideration among assets.
(3) Certain costs.
(4) Effect of agreement between parties.
(d) Examples.
(e) Reporting requirements.
(1) Applicable asset acquisitions.
(i) In general.
(ii) Time and manner of reporting.
(A) In general.
(B) Additional reporting requirement.
(2) Transfers of interests in partnerships.


    (b) Applicable asset acquisition--(1) In general. An applicable 
asset acquisition is any transfer, whether direct or indirect, of a 
group of assets if the assets transferred constitute a trade or 
business in the hands of either the seller or the purchaser and, except 
as provided in paragraph (b)(8) of this section, the purchaser's basis 
in the transferred assets is determined wholly by reference to the 
purchaser's consideration.
    (2) Assets constituting a trade or business--(i) In general. For 
purposes of this section, a group of assets constitutes a trade or 
business if--

[[Page 43501]]

    (A) The use of such assets would constitute an active trade or 
business under section 355; or
    (B) Its character is such that goodwill or going concern value 
could under any circumstances attach to such group.
    (ii) Goodwill or going concern value. Goodwill is the value of a 
trade or business attributable to the expectancy of continued customer 
patronage. This expectancy may be due to the name or reputation of a 
trade or business or any other factor. Going concern value is the 
additional value that attaches to property because of its existence as 
an integral part of an ongoing business activity. Going concern value 
includes the value attributable to the ability of a trade or business 
(or a part of a trade or business) to continue functioning or 
generating income without interruption notwithstanding a change in 
ownership. It also includes the value that is attributable to the 
immediate use or availability of an acquired trade or business, such 
as, for example, the use of the revenues or net earnings that otherwise 
would not be received during any period if the acquired trade or 
business were not available or operational.
    (iii) Factors indicating goodwill or going concern value. In making 
the determination in paragraph (b)(2) of this section, all the facts 
and circumstances surrounding the transaction are taken into account. 
Whether sufficient consideration is available to allocate to goodwill 
or going concern value after the residual method is applied is not 
relevant in determining whether goodwill or going concern value could 
attach to a group of assets. Factors to be considered include--
    (A) The presence of any intangible assets (whether or not those 
assets are section 197 intangibles), provided, however, that the 
transfer of such an asset in the absence of other assets will not be a 
trade or business for purposes of section 1060;
    (B) The existence of an excess of the total consideration over the 
aggregate book value of the tangible and intangible assets purchased 
(other than goodwill and going concern value) as shown in the financial 
accounting books and records of the purchaser; and
    (C) Related transactions, including lease agreements, licenses, or 
other similar agreements between the purchaser and seller (or managers, 
directors, owners, or employees of the seller) in connection with the 
transfer.
    (3) Examples. The following examples illustrate paragraphs (b)(1) 
and (2) of this section:

    Example 1. S is a high grade machine shop that manufactures 
microwave connectors in limited quantities. It is a successful 
company with a reputation within the industry and among its 
customers for manufacturing unique, high quality products. Its 
tangible assets consist primarily of ordinary machinery for working 
metal and plating. It has no secret formulas or patented drawings of 
value. P is a company that designs, manufactures, and markets 
electronic components. It wants to establish an immediate presence 
in the microwave industry, an area in which it previously has not 
been engaged. P is acquiring assets of a number of smaller companies 
and hopes that these assets will collectively allow it to offer a 
broad product mix. P acquires the assets of S in order to augment 
its product mix and to promote its presence in the microwave 
industry. P will not use the assets acquired from S to manufacture 
microwave connectors. The assets transferred are assets that 
constitute a trade or business in the hands of the seller. Thus, P's 
purchase of S's assets is an applicable asset acquisition. The fact 
that P will not use the assets acquired from S to continue the 
business of S does not affect this conclusion.
    Example 2. S, a sole proprietor who operates a car wash, both 
leases the building housing the car wash and sells all of the car 
wash equipment to P. S's use of the building and the car wash 
equipment constitute a trade or business. P begins operating a car 
wash in the building it leases from S. Because the assets 
transferred together with the asset leased are assets which 
constitute a trade or business, P's purchase of S's assets is an 
applicable asset acquisition.
    Example 3. S, a corporation, owns a retail store business in 
State X and conducts activities in connection with that business 
enterprise that meet the active trade or business requirement of 
section 355. P is a minority shareholder of S. S distributes to P 
all the assets of S used in S's retail business in State X in 
complete redemption of P's stock in S held by P. The distribution of 
S's assets in redemption of P's stock is treated as a sale or 
exchange under sections 302(a) and 302(b)(3), and P's basis in the 
assets distributed to it is determined wholly by reference to the 
consideration paid, the S stock. Thus, S's distribution of assets 
constituting a trade or business to P is an applicable asset 
acquisition.
    Example 4. S is a manufacturing company with an internal 
financial bookkeeping department. P is in the business of providing 
a financial bookkeeping service on a contract basis. As part of an 
agreement for P to begin providing financial bookkeeping services to 
S, P agrees to buy all of the assets associated with S's internal 
bookkeeping operations and provide employment to any of S's 
bookkeeping department employees who choose to accept a position 
with P. In addition to selling P the assets associated with its 
bookkeeping operation, S will enter into a long term contract with P 
for bookkeeping services. Because assets transferred from S to P, 
along with the related contract for bookkeeping services, are a 
trade or business in the hands of P, the sale of the bookkeeping 
assets from S to P is an applicable asset acquisition.

    (4) Asymmetrical transfers of assets. If, under general principles 
of tax law, a seller is not treated as transferring the same assets as 
the purchaser is treated as acquiring, the assets acquired by the 
purchaser constitute a trade or business, and, except as provided in 
paragraph (b)(8) of this section, the purchaser's basis in the 
transferred assets is determined wholly by reference to the purchaser's 
consideration, then the purchaser is subject to section 1060.
    (5) Related transactions. Whether the assets transferred constitute 
a trade or business is determined by aggregating all transfers from the 
seller to the purchaser in a series of related transactions. Except as 
provided in paragraph (b)(8) of this section, all assets transferred 
from the seller to the purchaser in a series of related transactions 
are included in the group of assets among which the consideration paid 
or received in such series is allocated under the residual method. The 
principles of Sec. 1.338-1(c) are also applied in determining which 
assets are included in the group of assets among which the 
consideration paid or received is allocated under the residual method.
    (6) More than a single trade or business. If the assets transferred 
from a seller to a purchaser include more than one trade or business, 
then, in applying this section, all of the assets transferred (whether 
or not transferred in one transaction or a series of related 
transactions and whether or not part of a trade or business) are 
treated as a single trade or business.
    (7) Covenant entered into by the seller. If, in connection with an 
applicable asset acquisition, the seller enters into a covenant (e.g., 
a covenant not to compete) with the purchaser, that covenant is treated 
as an asset transferred as part of a trade or business.
    (8) Partial non-recognition exchanges. A transfer may constitute an 
applicable asset acquisition notwithstanding the fact that no gain or 
loss is recognized with respect to a portion of the group of assets 
transferred. All of the assets transferred, including the non-
recognition assets, are taken into account in determining whether the 
group of assets constitutes a trade or business. The allocation of 
consideration under paragraph (c) of this section is done without 
taking into account either the non-recognition assets or the amount of 
money or other property that is treated as transferred in exchange for 
the non-recognition assets (together, the non-recognition exchange 
property). The basis in and gain or loss recognized with respect to the 
non-recognition exchange property are

[[Page 43502]]

determined under such rules as would otherwise apply to an exchange of 
such property. The amount of the money and other property treated as 
exchanged for non-recognition assets is the amount by which the fair 
market value of the non-recognition assets transferred by one party 
exceeds the fair market value of the non-recognition assets transferred 
by the other (to the extent of the money and the fair market value of 
property transferred in the exchange). The money and other property 
that are treated as transferred in exchange for the non-recognition 
assets (and which are not included among the assets to which section 
1060 applies) are considered to come from the following assets in the 
following order: first from Class I assets, then from Class II assets, 
then from Class III assets, then from Class IV assets, then from Class 
V assets, then from Class VI assets, and then from Class VII assets. 
For this purpose, liabilities assumed (or to which a non-recognition 
exchange property is subject) are treated as Class I assets. See 
Example 1 in paragraph (d) of this section for an example of the 
application of section 1060 to a single transaction which is, in part, 
a non-recognition exchange.
    (c) Allocation of consideration among assets under the residual 
method--(1) Consideration. The seller's consideration is the amount, in 
the aggregate, realized from selling the assets in the applicable asset 
acquisition under section 1001(b). The purchaser's consideration is the 
amount, in the aggregate, of its cost of purchasing the assets in the 
applicable asset acquisition that is properly taken into account in 
basis.
    (2) Allocation of consideration among assets. For purposes of 
determining the seller's amount realized for each of the assets sold in 
an applicable asset acquisition, the seller allocates consideration to 
all the assets sold by using the residual method under Secs. 1.338-6 
and 1.338-7, substituting consideration for ADSP. For purposes of 
determining the purchaser's basis in each of the assets purchased in an 
applicable asset acquisition, the purchaser allocates consideration to 
all the assets purchased by using the residual method under 
Secs. 1.338-6 and 1.338-7, substituting consideration for AGUB. In 
allocating consideration, the rules set forth in paragraphs (c)(3) and 
(4) of this section apply in addition to the rules in Secs. 1.338-6 and 
1.338-7.
    (3) Certain costs. The seller and purchaser each adjusts the amount 
allocated to an individual asset to take into account the specific 
identifiable costs incurred in transferring that asset in connection 
with the applicable asset acquisition (e.g., real estate transfer costs 
or security interest perfection costs). Costs so allocated increase, or 
decrease, as appropriate, the total consideration that is allocated 
under the residual method. No adjustment is made to the amount 
allocated to an individual asset for general costs associated with the 
applicable asset acquisition as a whole or with groups of assets 
included therein (e.g., non-specific appraisal fees or accounting 
fees). These latter amounts are taken into account only indirectly 
through their effect on the total consideration to be allocated.
    (4) Effect of agreement between parties. If, in connection with an 
applicable asset acquisition, the seller and purchaser agree in writing 
as to the allocation of any amount of consideration to, or as to the 
fair market value of, any of the assets, such agreement is binding on 
them to the extent provided in this paragraph (c)(4). Nothing in this 
paragraph (c)(4) restricts the Commissioner's authority to challenge 
the allocations or values arrived at in an allocation agreement. This 
paragraph (c)(4) does not apply if the parties are able to refute the 
allocation or valuation under the standards set forth in Commissioner 
v. Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967) 
(a party wishing to challenge the tax consequences of an agreement as 
construed by the Commissioner must offer proof that, in an action 
between the parties to the agreement, would be admissible to alter that 
construction or show its unenforceability because of mistake, undue 
influence, fraud, duress, etc.).
    (d) Examples. The following examples illustrate this section:

    Example 1. (i) On January 1, 2001, A transfers assets X, Y, and 
Z to B in exchange for assets D, E, and F plus $1,000 cash.
    (ii) Assume the exchange of assets constitutes an exchange of 
like-kind property to which section 1031 applies. Assume also that 
goodwill or going concern value could under any circumstances attach 
to each of the DEF and XYZ groups of assets and, therefore, each 
group constitutes a trade or business under section 1060.
    (iii) Assume the fair market values of the assets and the amount 
of money transferred are as follows:

----------------------------------------------------------------------------------------------------------------
                            By A                                                     By B
----------------------------------------------------------------------------------------------------------------
                                                 Fair market                                         Fair market
                     Asset                          value                     Asset                     value
----------------------------------------------------------------------------------------------------------------
X.............................................         $400   D....................................          $40
Y.............................................          400   E....................................           30
Z.............................................          200   F....................................           30
                                                              Cash (amount)........................        1,000
                                               --------------                                       ------------
    Total.....................................       $1,000         Total..........................       $1,100
----------------------------------------------------------------------------------------------------------------

    (iv) Under paragraph (b)(8) of this section, for purposes of 
allocating consideration under paragraph (c) of this section, the 
like-kind assets exchanged and any money or other property that are 
treated as transferred in exchange for the like-kind property are 
excluded from the application of section 1060.
    (v) Since assets X, Y, and Z are like-kind property, they are 
excluded from the application of the section 1060 allocation rules.
    (vi) Since assets D, E, and F are like-kind property, they are 
excluded from the application of the section 1060 allocation rules. 
In addition, $900 of the $1,000 cash B gave to A for A's like-kind 
assets is treated as transferred in exchange for the like-kind 
property in order to equalize the fair market values of the like-
kind assets. Therefore, $900 of the cash is excluded from the 
application of the section 1060 allocation rules.
    (vii) $100 of the cash is allocated under section 1060 and 
paragraph (c) of this section.
    (viii) A, as transferor of assets X, Y, and Z, received $100 
that must be allocated under section 1060 and paragraph (c) of this 
section. Since A transferred no Class I, II, III, IV, V, or VI 
assets to which section 1060 applies, in determining its amount 
realized for the part of the exchange to which section 1031 does not 
apply, the $100 is allocated to Class VII assets (goodwill and going 
concern value).
    (ix) A, as transferee of assets D, E, and F, gave consideration 
only for assets to which section 1031 applies. Therefore, the 
allocation rules of section 1060 and paragraph (c) of this section 
are not applied to determine the bases of the assets A received.

[[Page 43503]]

    (x) B, as transferor of assets D, E, and F, received 
consideration only for assets to which section 1031 applies. 
Therefore, the allocation rules of section 1060 do not apply in 
determining B's gain or loss.
    (xi) B, as transferee of assets X, Y, and Z, gave A $100 that 
must be allocated under section 1060 and paragraph (c) of this 
section. Since B received from A no Class I, II, III, IV, V, or VI 
assets to which section 1060 applies, the $100 consideration is 
allocated by B to Class VII assets (goodwill and going concern 
value).
    Example 2. (i) On January 1, 2001, S, a sole proprietor, sells 
to P, a corporation, a group of assets that constitutes a trade or 
business under paragraph (b)(2) of this section. S, who plans to 
retire immediately, also executes in P's favor a covenant not to 
compete. P pays S $3,000 in cash and assumes $1,000 in liabilities. 
Thus, the total consideration is $4,000.
    (ii) On the purchase date, P and S also execute a separate 
agreement that states that the fair market values of the Class II, 
Class III, Class V, and Class VI assets S sold to P are as follows:

------------------------------------------------------------------------
                                                                  Fair
       Asset class                        Asset                  market
                                                                 value
------------------------------------------------------------------------
II.......................  Actively traded securities........       $500
                                                              ----------
                               Total Class II................        500
III......................  Accounts receivable...............        200
                                                              ----------
                               Total Class III...............        200
V........................  Furniture and fixtures............        800
                           Building..........................        800
                           Land..............................        200
                           Equipment.........................        400
                                                              ----------
                               Total Class V.................      2,200
VI.......................  Covenant not to compete...........        900
                                                              ----------
                               Total Class VI................        900
------------------------------------------------------------------------

    (iii) P and S each allocate the consideration in the transaction 
among the assets transferred under paragraph (c) of this section in 
accordance with the agreed upon fair market values of the assets, so 
that $500 is allocated to Class II assets, $200 is allocated to the 
Class III asset, $2,200 is allocated to Class V assets, $900 is 
allocated to Class VI assets, and $200 ($4,000 total consideration 
less $3,800 allocated to assets in Classes II, III, V, and VI) is 
allocated to the Class VII assets (goodwill and going concern 
value).
    (iv) In connection with the examination of P's return, the 
District Director, in determining the fair market values of the 
assets transferred, may disregard the parties' agreement. Assume 
that the District Director correctly determines that the fair market 
value of the covenant not to compete was $500. Since the allocation 
of consideration among Class II, III, V, and VI assets results in 
allocation up to the fair market value limitation, the $600 of 
unallocated consideration resulting from the District Director's 
redetermination of the value of the covenant not to compete is 
allocated to Class VII assets (goodwill and going concern value).

    (e) Reporting requirements--(1) Applicable asset acquisitions--(i) 
In general. Unless otherwise excluded from this requirement by the 
Commissioner, the seller and the purchaser in an applicable asset 
acquisition each must report information concerning the amount of 
consideration in the transaction and its allocation among the assets 
transferred. They also must report information concerning subsequent 
adjustments to consideration.
    (ii) Time and manner of reporting--(A) In general. The seller and 
the purchaser each must file asset acquisition statements on Form 8594 
with their income tax returns or returns of income for the taxable year 
that includes the first date assets are sold pursuant to an applicable 
asset acquisition. This reporting requirement applies to all asset 
acquisitions described in this section. For reporting requirements 
relating to asset acquisitions occurring before the date final 
regulations are published in the Federal Register, as described in 
paragraph (a)(2) of this section, see the temporary regulations under 
section 1060 in effect prior to the date final regulations are 
published in the Federal Register (Sec. 1.1060-1T as contained in 26 
CFR part 1 revised April 1, 1999).
    (B) Additional reporting requirement. When an increase or decrease 
in consideration is taken into account after the close of first taxable 
year that includes the first date assets are sold in an applicable 
asset acquisition, the seller and the purchaser each must file a 
supplemental asset acquisition statement on Form 8594 with the income 
tax return or return of income for the taxable year in which the 
increase (or decrease) is properly taken into account.
    (2) Transfers of interests in partnerships. For reporting 
requirements relating to the transfer of the partnership interest, see 
Sec. 1.755-2T(c).


Sec. 1.1060-1T  [Removed]

    Par. 11. Section 1.1060-1T is removed.

PART 602--OMB CONTROL NUMBERS UNDER PAPERWORK REDUCTION ACT

    Par. 12. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


Sec. 602.101  [Amended]

    Par. 13. In Sec. 602.101, paragraph (b) is amended by removing the 
entries for 1.338(b)-1 and 1.1060-1T from the table.
John M. Dalrymple,
Acting Deputy Commissioner of Internal Revenue.
[FR Doc. 99-19930 Filed 8-4-99; 9:14 am]
BILLING CODE 4830-01-U