[Federal Register Volume 66, Number 30 (Tuesday, February 13, 2001)]
[Rules and Regulations]
[Pages 9925-9957]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-981]



[[Page 9925]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8940]
RIN 1545-AY73


Purchase Price Allocations in Deemed and Actual Asset 
Acquisitions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final regulations relating to deemed 
and actual asset acquisitions under sections 338 and 1060. The final 
regulations affect sellers and buyers of corporate stock that are 
eligible to elect to treat the transaction as a deemed asset 
acquisition. The final regulations also affect sellers and buyers of 
assets that constitute a trade or business.

DATES: Effective Date: These regulations are effective March 16, 2001.
    Applicability Dates: For dates of applicability of these 
regulations, see Secs. 1.338(i)-1 and 1.1060-1(a)(2).

FOR FURTHER INFORMATION CONTACT: Richard Starke of the Office of 
Associate Chief Counsel (Corporate), (202) 622-7790 (not a toll-free 
number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under the control number 1545-1658.
    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.
    The collections of information in these 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 regulations provide 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 regulations also provide 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. 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. 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.
    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.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S:O, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    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

    On August 10, 1999, the IRS and the Department of Treasury 
(Treasury) published a notice of proposed rulemaking in the Federal 
Register (REG-107069-97, 64 FR 43462 (1999-36 I.R.B. 346)) containing 
proposed regulations under sections 338 and 1060 of the Internal 
Revenue Code of 1986. On January 7, 2000, the IRS and Treasury 
published temporary regulations in the Federal Register (REG-107069-97, 
65 FR 1236 (2000-4 I.R.B. 332)) that are virtually the same as the 
proposed regulations published on August 10, 1999. The preamble to the 
temporary regulations notes that the proposed regulations generally 
were favorably received and that the IRS and Treasury believe that the 
proposed regulations provided clearer guidance and better rules than 
the prior regulations under sections 338 and 1060. However, the 
preamble also notes that the comments received warranted further 
consideration.

Explanation of Provisions

    In general, the final regulations adopted herein are very similar 
to the proposed and temporary regulations in their organization and 
substance. However, changes have been made in several areas, largely in 
response to the comments received. The principal changes are discussed 
below, in the order in which they appear in the regulations.

Insurance Transactions

    Although section 338 treats a target as having sold all its assets 
in the deemed asset sale, proposed Sec. 1.338-1(a)(2) provides that 
other rules of law may characterize the transaction as something other 
than or in addition to a sale and purchase of assets. Proposed 
Sec. 1.338-1(a)(2) states: ``[f]or 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.'' Several comments 
urged removal of the quoted sentence in the final regulations and 
recommended that the treatment of transactions involving insurance 
companies under section 338 be reserved pending more complete analysis 
and guidance. The IRS and Treasury believe that generally it is 
appropriate to view the deemed asset sale by an insurance company as 
involving an assumption-reinsurance transaction and, therefore, have 
retained the sentence in the final regulations. The IRS and Treasury, 
however, intend to provide additional guidance in a separate project.

Residual Method Anti-abuse Rule

    The proposed regulations include a new anti-abuse rule intended to 
prevent taxpayers from changing the results of applying the residual 
method by engaging in transactions that have a transitory economic 
effect with respect to the ownership or use of assets. The anti-abuse 
rule is intended to apply only to an asset transfer exhibiting 
objective characteristics suggesting the transfer was engaged in to 
manipulate the operation of the residual method.

[[Page 9926]]

    Notwithstanding the limited scope of the anti-abuse rule, several 
commentators suggested further limiting or eliminating the rule. After 
studying the comments, the IRS and Treasury continue to believe that 
the anti-abuse rule serves a useful purpose in protecting the operation 
of the residual method. Several changes have been made, however, to 
clarify the intended scope of the rule. Thus, the phrase ``to more than 
an insignificant extent'' is changed in the final regulation to 
``primarily.'' This change is meant to clarify that some continuing use 
in its original location of an asset transferred to or from the target 
is permitted.
    A comment requested that the final regulations elaborate further on 
the statement that the Commissioner has the authority to make 
appropriate correlative adjustments and that the final regulations 
include an example. The final regulations do not do so, because the 
nature of any correlative adjustments would depend on the particular 
factual circumstances in which the rule is applied. Thus, any 
additional guidance would provide only limited assistance. However, the 
final regulations state that correlative adjustments should avoid 
duplication or omission of any item of income, gain, loss, deduction, 
or basis. See Sec. 1.338-1(c).

Closing Date Issues

    Concerns have been raised about the possibility that buyers can 
effectuate transactions outside the ordinary course of business after 
acquiring target stock that, to the detriment of an unsuspecting 
seller, must be reported by the seller on its return, which normally 
covers the entire day on which the acquisition occurs. Some of these 
concerns derive from a reading of Sec. 1.1502-76(b) to preclude 
operation of the ``next day rule'' whenever a section 338 election is 
made for a target. The ``next day rule'' of Sec. 1.1502-76(b) provides 
that if, on the day of a group member's change in status as a member, a 
transaction occurs that is properly allocable to the portion of the 
member's day after the event resulting in the change, the member and 
all related persons must treat the transaction as occurring at the 
beginning of the following day.
    Commentators have suggested that a purchaser acquiring stock of a 
subsidiary member of a consolidated group could, after acquiring the 
target stock, cause the target to sell all of its assets to another 
person later on the closing date and then make a unilateral section 
338(g) election. It is suggested that the effect of the election is to 
preclude the operation of the next day rule, causing the results of the 
actual asset sale to fall onto the selling consolidated group's tax 
return. The IRS and Treasury do not believe that Sec. 1.1502-76(b), as 
written, automatically precludes the operation of the next day rule in 
a section 338 context, but nevertheless have provided a new rule in 
these final regulations that requires the application of the next day 
rule in a section 338 context where the target engages in a transaction 
outside the ordinary course of business on the acquisition date after 
the event resulting in the qualified stock purchase (QSP). See 
Sec. 1.338-1(d).

Purchase Definition

    Proposed Sec. 1.338-3(b)(2) provides rules concerning the 
definition of a ``purchase'' that require more than a nominal amount to 
be paid for the stock of the target. Several comments requested 
reconsideration of the proposed rule. Accordingly, in the temporary 
regulations, at Sec. 1.338-3T(b)(2), a definition is given for the term 
purchase of target affiliate, while the definition of the term purchase 
of target is reserved. The final regulations include a single 
definition of purchase applicable to both targets and target 
affiliates, which definition generally conforms to the definition of 
purchase of target affiliate in the temporary regulations. Under this 
definition, stock in a target (or target affiliate) may be considered 
purchased if, under general principles of tax law, the purchasing 
corporation is considered to own stock of the target (or target 
affiliate) meeting the requirements of section 1504(a)(2), 
notwithstanding that no amount may be paid for (or allocated to) the 
stock.

Transactions After QSPs

    Since 1995, the regulations under section 338 have provided special 
rules that apply, by virtue of section 338, to certain transfers of 
target assets following a QSP of the target's stock if a section 338 
election is not made for the target. These provisions modify the normal 
operation of the continuity of interest requirement under section 368 
and the interpretation of the term shareholder for purposes of section 
368(a)(1)(D), as applied to certain taxpayers. These rules were adopted 
to effectuate Congressional intent, in replacing former section 
334(b)(2) with section 338, that the deemed sale results provided by 
section 338 not be available through transactions within the purchasing 
group after the acquisition. In the final regulations, these rules are 
located at Sec. 1.338-3(d).
    The 1995 amendments did not provide any special rule to modify the 
application of the statutory requirements for reorganizations under 
section 368(a)(1)(C). However, the considerations that justify the 
modified application of the continuity of interest rule and the 
shareholder definition for ``D'' reorganizations also justify an 
analogous modification of the ``solely for voting stock'' requirement 
for post-acquisition ``C'' reorganizations. Accordingly, the final 
regulations provide that consideration other than voting stock issued 
in connection with a QSP is ignored in determining whether a subsequent 
transfer of assets by the target corporation to a member of its new 
affiliated group satisfies the solely for voting stock requirement of a 
``C'' reorganization. See Sec. 1.338-3(d)(4).

Treatment of Liabilities

    The proposed regulations eliminate the prior distinction between 
``modified aggregate deemed sale price'' (or MADSP) and ``aggregate 
deemed sale price'' (or ADSP), a distinction that appeared to have been 
based on the premise that the new target generally will not bear the 
tax liability for the deemed sale where a section 338(h)(10) election 
is made, but that it generally will bear the liability where a section 
338 (but not section 338(h)(10)) election is made. However, these 
generalizations were not universally correct in either situation. 
Proposed Secs. 1.338-4 and 1.338-5 clarify the treatment of taxes as 
liabilities in computing ADSP and ``adjusted grossed-up basis'' (or 
AGUB). Commentators asked for further clarification of the standards 
for taking certain taxes into account. Rather than providing more 
specific guidance, which would be inconsistent with the overall 
philosophy of deferring to general tax principles governing actual 
transactions, the final regulations further simplify the discussion of 
liabilities. Except for the fact that new target remains liable for old 
target's tax liabilities (see Sec. 1.338-1(b)(3)(i)) and that a buyer's 
assumption of a seller's income tax liability with respect to the sale 
causes the consideration to ``gross up'' or ``pyramid,'' a tax 
liability is like any other type of liability and the status of any 
particular type of tax liability as a liability includible in ADSP or 
AGUB should be determined under general principles as applied to the 
facts relating to the incidence of the tax liability.

Valuation Rules

    Proposed Sec. 1.338-6(a)(2)(iii) retains a statement from prior 
versions of the regulations that ``[i]n certain cases the IRS may make 
an independent showing of the value of goodwill and going

[[Page 9927]]

concern value as a means of calling into question the validity of the 
taxpayer's valuation of other assets.'' This authority was intended to 
provide a means of ensuring that taxpayers do not overvalue assets in 
higher classes that are allocated consideration before the residual 
class. As a factual matter, the IRS and Treasury understand that a low 
(or no) allocation to goodwill and going concern value may result from 
causes other than a taxpayer's overvaluation of assets in higher 
classes. Moreover, the IRS and Treasury accept the soundness of the 
fundamental premise of the residual method that goodwill and going 
concern value are the most difficult assets to value independently and 
that their value should be computed as the residue after all other 
assets are valued. The final regulations delete the sentence about 
valuing goodwill and going concern value. Under the final regulations, 
the IRS retains the ability to challenge a taxpayer's valuation of 
assets in Classes I through VI, but will do so on grounds consistent 
with the residual method of allocation.

Top-Down Allocation

    Changes to the rules for allocating purchase price to the stock and 
assets of lower tier subsidiaries were not proposed, although, as noted 
in the preamble to the proposed regulations, considerable study was 
given to alternative approaches. Comments were requested, but none was 
received, and the IRS and Treasury to date have been unable to develop 
a fully successful alternative. Accordingly, the final regulations 
continue to apply the ``top-down'' allocation system, under which the 
stock of a lower tier subsidiary is allocated purchase price in the 
general asset category (now Class V) and the deemed purchase price of 
its assets is in turn computed from that stock price and then allocated 
within the subsidiary.
    In the final regulations, the scope of Class II assets described in 
Sec. 1.338-6(b)(2)(ii) is modified to provide that Class II assets do 
not include stock of target affiliates, other than actively traded 
stock described in section 1504(a)(4) (certain preferred stock). 
Instead, stock of target affiliates is included in Class V. This would 
exclude target affiliate stock from Class II where the target holds an 
80 percent or greater interest in the target affiliate but a minority 
interest in target affiliate stock of the same class is actively 
traded. It is not clear that the trading price for shares of a class of 
stock less than 20 percent of which is in the hands of the public, and 
which consequently may experience thinner trading volumes, necessarily 
is indicative of the fair market value of the 80 percent or greater 
majority interest.

Class III Assets

    Proposed Sec. 1.338-6(b)(2) provides that Class III assets consist 
of ``accounts receivable, mortgages, and credit card receivables from 
customers which arise in the ordinary course of business.'' Comments 
suggested that these categories were too limited. Under the rationales 
expressed in the preamble to the proposed regulations, the IRS and 
Treasury believe that other types of debt instruments, and even other 
types of assets, should be included in Class III. As revised in the 
final regulations, Class III assets generally consist of assets that 
the taxpayer marks to market at least annually and debt instruments 
(including receivables). However, debt instruments issued by related 
parties, and certain contingent payment and convertible debt 
instruments, are not included in Class III.

First Year Price Adjustments

    Proposed Sec. 1.338-7 provides rules for allocating the ADSP or 
AGUB when increases or decreases are required after the close of new 
target's first taxable year. For increases or decreases required before 
the end of new target's first taxable year, proposed Sec. 1.338-
4(b)(2)(ii) provides that ``[i]ncreases 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 tax consequences as if they had 
been taken into account at the beginning of the day after the 
acquisition date.'' Proposed Sec. 1.338-5(b)(2)(ii) contains a similar 
rule for redeterminations of AGUB. These rules originated in 
predecessor versions of the regulations under section 338.
    Although no commentator requested removal of these rules, one 
comment highlighted the difficulties posed for the seller in section 
338(h)(10) transactions in applying a rule based on new target's year-
end, and requested relief. After reviewing this comment, the final 
regulations remove the rules providing special treatment for changes in 
ADSP or AGUB occurring before the close of new target's first taxable 
year. Instead, the general rule in Sec. 1.338-7 governs the allocation 
of all changes in ADSP or AGUB after the acquisition date. This change 
is consistent with the IRS's and Treasury's expressed intent in 
drafting the proposed regulations to eliminate, to the extent possible, 
any special accounting rules in the section 338 regulations, as it 
should result in treatment more consistent with that of an actual asset 
sale.

Like-kind Exchanges

    A commentator suggested that the final regulations should apply 
section 1031 to old target in its deemed asset sale if the purchaser 
pays for target stock with property of like kind to old target's assets 
or with cash put in escrow for a successor to old target to designate 
for purchase of assets of like kind. This rule would be an exception to 
the requirement in Sec. 1.338-1(a)(2) that the transaction between old 
target and new target must be a taxable transaction, and inconsistent 
with the requirement of section 338(a)(1) that target ``shall be 
treated as having sold all of its assets at the close of the 
acquisition date at fair market value * * *'' After considering the 
policy concerns and the administrative difficulties in creating and 
administering an exception for section 1031 exchanges, the IRS and 
Treasury have not adopted this suggestion.

S Corporations

    A purchaser may agree to compensate the sellers of an S corporation 
target for adverse tax consequences resulting from a section 338(h)(10) 
election. When more than one shareholder in an S corporation sells 
stock in the same transaction, the different shareholders may negotiate 
different prices for their stock based on varying Federal and state tax 
liabilities they will bear as a result of the transaction. Some 
commentators have noted that, in other cases, different prices may be 
paid for control premiums or other reasons. Under section 
1361(b)(1)(D), an S corporation is permitted to have only one class of 
stock. A potential second class of stock issue arises because the 
fiction of a section 338(h)(10) election is that the target sells its 
assets to a new target and then liquidates. Applying that fiction, if 
the shareholders are treated as receiving differing amounts per share 
in the deemed liquidation, a second class of stock could result.
    Some commentators have recommended that the final regulations 
clarify that the payment of varying amounts per share to S corporation 
shareholders will not cause the S corporation to violate the single 
class of stock requirement. The final regulations respond to these 
comments by including a statement in Sec. 1.1361-1(l)(2)(v) that the 
payment of varying amounts to S corporation shareholders in a 
transaction for which a section 338(h)(10) election is made will not 
cause the S corporation to violate the single class of stock 
requirement of

[[Page 9928]]

section 1361(b)(1)(D) and Sec. 1.1361-1(l), provided that the varying 
amounts are negotiated in arm's length negotiations with the purchaser.
    One commentator requested clarification regarding the calculation 
and allocation of the purchaser's AGUB for a target that was an S 
corporation that owned a qualified subchapter S subsidiary (QSub), 
where the QSub status does not continue after the acquisition date and 
the QSub is treated as becoming a separate subsidiary of new target. 
Although the regulations require allocation of the AGUB among the 
target's assets held at the beginning of the day after the acquisition 
date, they also require results consistent with those that would occur 
if the parties had actually engaged in the transactions deemed to occur 
because of section 338(h)(10), and taking into account other 
transactions that actually occurred or are deemed to occur. See 
Sec. 1.338(h)(10)-1(d)(9). An actual sale of the assets of the S 
corporation target, including the stock of the QSub, to a corporation 
would be treated as a sale by the S corporation of all of its assets, 
including those of the QSub. If the QSub status does not continue after 
the acquisition, the buyer would be treated as forming a new subsidiary 
containing the assets held by the former QSub. See Sec. 1.1361-5(b)(3) 
Example 9. Accordingly, the AGUB for the former S corporation target 
would be allocated among the assets of the former QSub as though they 
were assets of the target, and then the target would be treated as 
having formed a new subsidiary containing the assets of the former 
QSub.
    Clarification was also requested regarding the possibility of 
making a section 338(h)(10) election for the sale by an S corporation 
of stock of a QSub. As noted above, Example 9 of Sec. 1.1361-5(b)(3) 
indicates that the sale by an S corporation of all of the stock of a 
QSub is treated as an asset sale by the S corporation to the purchaser 
of the QSub stock. No further guidance is provided in these 
regulations. The sale of an 80 percent or greater (but less than 100 
percent) interest in the stock of a QSub is not expected to be a common 
transaction because it generally will result in a taxable transaction 
with respect to all the assets of the QSub.

Forms 8023 and 8594

    The current temporary regulations provide that a section 338(h)(10) 
election for an S corporation target must be made jointly by the 
purchaser and the S corporation shareholders. These regulations 
specifically require nonselling S corporation shareholders to consent 
to the election. See Sec. 1.338(h)(10)-1T(c)(2). However, the 
instructions for the election form (Form 8023) do not clearly require 
the nonselling shareholders to sign the election form. Moreover, the 
prior regulations were less clear in requiring nonselling S corporation 
shareholders to consent to the election. Commentators have requested 
that the IRS recognize the validity of section 338(h)(10) elections for 
S corporation targets even if not signed by nonselling shareholders. 
The IRS will revise Form 8023 to make clear that nonselling S 
corporation shareholders must also sign. The IRS will recognize the 
validity of otherwise valid elections made on the current version of 
the form even if not signed by the nonselling shareholders, provided 
that the S corporation and all of its shareholders (including 
nonselling shareholders) report the tax consequences consistently with 
the results under section 338(h)(10). See Sec. 1.338(i)-1(b).
    The preamble to the proposed regulations indicates that the IRS and 
Treasury were considering requiring that the information about the 
allocation of ADSP and AGUB currently submitted on the election form 
(Form 8023) instead be submitted by the purchaser and seller(s) 
separately on their income tax returns. Such a change will be 
effectuated when Form 8023 is revised. The information about ADSP and 
AGUB will be reported by each party separately on Form 8594, which also 
will be revised. With respect to a transaction subject to a section 338 
election, Form 8594 will be filed with the income tax returns of the 
old and new target for the tax periods including the deemed sale and 
purchase. Where an election under section 338(g) is made for a 
controlled foreign corporation (CFC), the purchaser and seller (or 
their U.S. shareholder(s)) will be required to submit separately, on 
Form 8594, information about ADSP and AGUB. The Form 8594 will be 
required to be attached to the last Form 5471 filed by the seller for 
old target, and to the first Form 5471 filed by the purchaser for new 
target.

Special Analyses

    It has been determined that these final regulations are not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has been 
determined that a final regulatory flexibility analysis is required for 
the collection of information in this Treasury decision under 5 U.S.C. 
604. This analysis is set forth below under the heading ``Final 
Regulatory Flexibility Act Analysis.'' Pursuant to section 7805(f) of 
the Internal Revenue Code, these final regulations will be submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

Final Regulatory Flexibility Act Analysis

    This analysis is required under the Regulatory Flexibility Act (5 
U.S.C. chapter 6). 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 final regulations will significantly improve the clarity of the 
rules relating to both deemed and actual asset acquisitions.
    The major objective of these final regulations is to modify the 
rules for allocating purchase price in both deemed and actual asset 
acquisitions. In addition, these final 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 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. The 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

[[Page 9929]]

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.

Drafting Information

    The principal author of these regulations is Richard Starke, Office 
of the Associate Chief Counsel (Corporate). However, other personnel 
from the IRS and Treasury Department participated extensively in their 
development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entries for Sections 1.338-6T, 1.338-7T, 1.338-10T 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 1.338-10 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. In the list below, for each section indicated in the left 
column, remove the language in the middle column and add the language 
in the right column:

----------------------------------------------------------------------------------------------------------------
               Section                                   Remove                                 Add
----------------------------------------------------------------------------------------------------------------
1.56(g)-1(k)(1), second sentence.....  of Sec.  1.338-6T(b), if otherwise          of Sec.  1.338-6(b), if
                                                                                    otherwise
1.56(g)-1(k)(1), last sentence.......  of Sec.  1.338-6T(c)(1) and (2) also        of Sec.  1.338-6(c)(1) and
                                                                                    (2) also
1.197-2(e)(1), second sentence.......  See Sec.  1.1060-1T(b)(2)                   See Sec.  1.1060-1(b)(2)
1.197-2(k), Example 6, paragraph (i),  See Sec.  1.338-6T(b)                       See Sec.  1.338-6(b)
 last sentence.
1.197-2(k), Example 6, paragraph       Under Secs.  1.1060-1T(c)(2) and 1.338-     Under Secs.  1.1060-1(c)(2)
 (ii), second sentence.                 6T(c)(1)                                    and 1.338-6(c)(1)
1.197-2(k), Example 6, paragraph       See Secs.  1.1060-1T(c)(2) and 1.338-6T(b)  See Secs.  1.1060-1(c)(2) and
 (ii), last sentence.                                                               1.338-6(b)
1.197-2(k), Example 23, paragraph      (as these terms are defined as in defined   (as these terms are defined
 (iv), first sentence.                  in Sec.  1.338-1(c)(13))                    as in defined in Sec.  1.338-
                                                                                    2(c)(17))
1.338-8(h)(1), last sentence.........  nomenclature of Sec.  1.338-1(b) and (c)    nomenclature of sentence Sec.
                                        and                                          1.338-2(b) and (c) and
1.338-9(a), penultimate sentence.....  provided in Sec.  1.338-1(c)(14),           provided in Sec.  1.338-
                                                                                    2(c)(18),
1.338-9(b)(1), first sentence........  the deemed sale gain, as defined in Sec.    the deemed sale tax sentence
                                        1.338-3(b)(4),                              consequences, as defined in
                                                                                    Sec.  1.338-2(c)(7),
1.338-9(b)(1), last sentence.........  the deemed sale gain                        the deemed sale tax
                                                                                    consequences.
1.338-9(b)(3)(i)(B)..................  under Sec.  1.338(b)-1(e)(2)                under Sec.  1.338-5(d).
1.338-9(b)(3)(ii)....................  reflect deemed sale gain)                   reflect deemed sale tax
                                                                                    consequences)
1.338-9(b)(4)........................  under Sec.  1.338(b)-1(e)(2),               under Sec.  1.338-5(d),
1.338-9(f)(2), Example 1, paragraph    and Sec.  1.338(b)-1(e)(2)                  and Sec.  1.338-5(d).
 (a), last sentence.
1.368-1(a), third sentence...........  (k) and 1.338-3T(c)(3)                      (k) and 1.338-3(d).
1.368-1(e)(6), Example 4, paragraph    see Sec.  1.338-3T(c)(3) (which             see Sec.  1.338-3(d) (which
 (ii), last sentence.
1.597-2(d)(5)(iii)(B)................  (see Sec.  1.338-7T)                        (see Sec.  1.338-7)
1.597-5(c)(3)(i).....................  under Sec.  1.338-6T(b), (c)(1) and (2)     under Sec.  1.338-6(b),
                                                                                    (c)(1) and (2).
1.597-5(d)(2)(i).....................  under Sec.  1.338-6T(b), (c)(1) and (2)     under Sec.  1.338-6(b),
                                                                                    (c)(1) and (2).
1.921-1T(b)(1), A-1, immediately       and Sec.  1.338-2T(d)                       and Sec.  1.338-2(d)
 proceding the penultimate sentence.
1.1031(d)-1T, last sentence..........  see Sec.  1.1060-1T(b), (c), and (d)        see Sec.  1.1060-1(b), (c),
                                        Example 1                                   and (d) Example 1.
1.1031(j)-1(b)(2)(iii), penultimate    in Sec.  1.338-6T(b), to which reference    in Sec.  1.338-6(b), to which
 sentence.                              is made by Sec.  1.1060-1T(c)(2)            reference is made by Sec.
                                                                                    1.1060-1(c)(2).
1.1361-4(d), Example 3, third          Under section 338(a) and Sec.               Under section 338(a) and Sec.
 sentence.                              1.338(h)(10)-1T(d)(3),                       1.338(h)(10)-1(d)(3),
1.1502-75(k).........................  See Sec.  1.338(h)(10)-1T(d)(7) for         See Sec.  1.338(h)(10)-
                                                                                    1(d)(7) for
1.1502-76(b)(1)(ii)(A)(1), last        See Sec.  1.338-10T(a)(5) (deemed           See Sec.  1.338-10(a)(5)
 sentence.                                                                          (deemed
----------------------------------------------------------------------------------------------------------------


    Par. 3. Sections 1.338-0 through 1.338-7 are added 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:

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

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

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

    (a) Scope.
    (b) Nomenclature.
    (c) Definitions.
    (1) Acquisition date.
    (2) Acquisition date assets.
    (3) Affiliated group.
    (4) Common parent.
    (5) Consistency period.
    (6) Deemed asset sale.
    (7) Deemed sale tax consequences.
    (8) Deemed sale return.

[[Page 9930]]

    (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.
    (ii) Qualifying foreign purchasing corporation.
    (iii) Qualifying foreign target.
    (iv) Triggering event.
    (v) Subject to United States tax.
    (2) Acquisition period.
    (3) Statement of section 338 may be filed by United States 
shareholders in certain cases.
    (4) Notice requirement for U.S. persons holding stock in foreign 
target.
    (i) General rule.
    (ii) Limitation.
    (iii) Form of notice.
    (iv) Timing of notice.
    (v) Consequence of failure to comply.
    (vi) Good faith effort to comply.

 1.338-3  Qualification for the section 338 election.

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

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

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

 1.338-5  Adjusted grossed-up basis.

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

 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.

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

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

 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.

[[Page 9931]]

    (d) Basis of acquired assets.
    (1) Carryover basis rule.
    (2) Exceptions to carryover basis rule for certain assets.
    (3) Exception to carryover basis rule for de minimis assets.
    (4) Mitigation rule.
    (i) General rule.
    (ii) Time for transfer.
    (e) Examples.
    (1) In general.
    (2) Direct acquisitions.
    (f) Extension of consistency to indirect acquisitions.
    (1) Introduction.
    (2) General rule.
    (3) Basis of acquired assets.
    (4) Examples.
    (g) Extension of consistency if dividends qualifying for 100 
percent dividends received deduction are paid.
    (1) General rule for direct acquisitions from target.
    (2) Other direct acquisitions having same effect.
    (3) Indirect acquisitions.
    (4) Examples.
    (h) Consistency for target affiliates that are controlled 
foreign corporations.
    (1) In general.
    (2) Income or gain resulting from asset dispositions.
    (i) General rule.
    (ii) Basis of controlled foreign corporation stock.
    (iii) Operating rule.
    (iv) Increase in asset or stock basis.
    (3) Stock issued by target affiliate that is a controlled 
foreign corporation.
    (4) Certain distributions.
    (i) General rule.
    (ii) Basis of controlled foreign corporation stock.
    (iii) Increase in asset or stock basis.
    (5) Examples.
    (i) [Reserved]
    (j) Anti-avoidance rules.
    (1) Extension of consistency period.
    (2) Qualified stock purchase and 12-month acquisition period.
    (3) Acquisitions by conduits.
    (i) Asset ownership.
    (A) General rule.
    (B) Application of carryover basis rule.
    (ii) Stock acquisitions.
    (A) Purchase by conduit.
    (B) Purchase of conduit by corporation.
    (C) Purchase of conduit by conduit.
    (4) Conduit.
    (5) Existence of arrangement.
    (6) Predecessor and successor.
    (i) Persons.
    (ii) Assets.
    (7) Examples.

 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.

 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.

 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.

 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 discharge of its 
liabilities (see Sec. 1.1001-2(a)), and new target is treated as 
acquiring all of its assets from an unrelated person in exchange for 
consideration that includes the assumption of those liabilities. (Such 
transaction is, without regard to its characterization for Federal 
income tax purposes, referred to as the deemed asset sale and the 
income tax

[[Page 9932]]

consequences thereof as the deemed sale tax consequences.) If a section 
338(h)(10) election is made, old target is deemed to liquidate 
following the deemed asset sale.
    (2) Application of other rules of law. Other rules of law apply to 
determine the tax consequences to the parties as if they had actually 
engaged in the transactions deemed to occur under section 338 and the 
regulations thereunder except to the extent otherwise provided in those 
regulations. See also Sec. 1.338-6(c)(2). Other rules of law may 
characterize the transaction as something other than or in addition to 
a sale and purchase of assets; however, the transaction between old and 
new target must be a taxable transaction. For example, if 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).
    (3) Overview. Definitions and special nomenclature and rules for 
making the section 338 election are provided in Sec. 1.338-2. 
Qualification for the section 338 election is addressed in Sec. 1.338-
3. The amount for which old target is treated as selling all of its 
assets (the aggregate deemed sale price, or ADSP) is addressed in 
Sec. 1.338-4. The amount for which new target is deemed to have 
purchased all its assets (the adjusted grossed-up basis, or AGUB) is 
addressed in Sec. 1.338-5. Section 1.338-6 addresses allocation both of 
ADSP among the assets old target is deemed to have sold and of AGUB 
among the assets new target is deemed to have purchased. Section 1.338-
7 addresses allocation of ADSP or AGUB when those amounts subsequently 
change. Asset and stock consistency are addressed in Sec. 1.338-8. 
International aspects of section 338 are covered in Sec. 1.338-9. Rules 
for the filing of returns are provided in Sec. 1.338-10. 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), 
and voluntary employee benefit associations (section 501(c)(9) and the 
regulations thereunder);
    (ii) Sections 1311 through 1314 (relating to the mitigation of the 
effect of limitations), if a section 338(h)(10) election is not made 
for target;
    (iii) Section 108(e)(5) (relating to the reduction of purchase 
money debt);
    (iv) Section 45A (relating to the Indian Employment Credit), 
section 51 (relating to the Work Opportunity Credit), section 51A 
(relating to the Welfare to Work Credit), and section 1396 (relating to 
the Empowerment Zone Act);
    (v) Sections 401(h) and 420 (relating to medical benefits for 
retirees);
    (vi) Section 414 (relating to definitions and special rules); and
    (vii) Any other provision designated in the Internal Revenue 
Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of 
this chapter. See, for example, Sec. 1.1001-3(e)(4)(i)(F) providing 
that an election under section 338 does not result in the substitution 
of a new obligor on target's debt.
    (3) General rule for other provisions of the Internal Revenue Code. 
Except as provided in the regulations under section 338 or in the 
Internal Revenue Bulletin by the Internal Revenue Service (see 
Sec. 601.601(d)(2)(ii) of this chapter), new target is treated as a 
continuation of old target for purposes other than subtitle A of the 
Internal Revenue Code. For example--
    (i) New target is liable for old target's Federal income tax 
liabilities, including the tax liability for the deemed sale tax 
consequences and those tax liabilities of the other members of any 
consolidated group that included old target that are attributable to 
taxable years in which those corporations and old target joined in the 
same consolidated return (see Sec. 1.1502-6(a));
    (ii) Wages earned by the employees of old target are considered 
wages earned by such employees from new target for purposes of sections 
3101 and 3111 (Federal Insurance Contributions Act) and section 3301 
(Federal Unemployment Tax Act); and
    (iii) Old target and new target must use the same employer 
identification number.
    (c) Anti-abuse rule--(1) In general. The rules of this paragraph 
(c) apply for purposes of applying the residual method as provided for 
under the regulations under sections 338 and 1060. The Commissioner is 
authorized to treat any property (including cash) transferred by old 
target in connection with the transactions resulting in the application 
of the residual method (and not held by target at the close of the 
acquisition date) as, nonetheless, property of target at the close of 
the acquisition date if the property so transferred is, within 24 
months after the deemed asset sale, owned by new target, or is owned, 
directly or indirectly, by a member of the affiliated group of which 
new target is a member and continues after the acquisition date to be 
held or used primarily in connection with one or more of the activities 
of new target. In addition, the Commissioner is authorized to treat any 
property (including cash) transferred to old target in connection with 
the transactions resulting in the application of the residual method 
(and held by target at the close of the acquisition date) as, 
nonetheless, not being property of target at the close of the 
acquisition date if the property so transferred is, within 24 months 
after the deemed asset sale, not owned by new target but owned, 
directly or indirectly, by a member of the affiliated group of which 
new target is a member, or owned by new target but held or used 
primarily in connection with an activity conducted, directly or 
indirectly, by another member of the affiliated group of which new 
target is a member in combination with other property retained by or 
acquired, directly or indirectly, from the transferor of the property 
(or a member of the same affiliated group) to old target. For purposes 
of this paragraph (c)(1), an interest in an entity is considered held 
or used in connection with an activity if property of the entity is so 
held or used. The authority of the Commissioner under this paragraph 
(c)(1) includes the making of any appropriate correlative adjustments 
(avoiding, to the extent possible, the

[[Page 9933]]

duplication or omission of any item of income, gain, loss, deduction, 
or basis).
    (2) Examples. The following examples illustrate this paragraph (c):

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

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


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 (but see Sec. 1.338-1(d) (regarding certain transactions on the 
acquisition date)).
    (3) Affiliated group. The term affiliated group has the same 
meaning as in section 338(h)(5). Corporations are affiliated on any day 
they are members of the same affiliated group.
    (4) Common parent. The term common parent has the same meaning as 
in section 1504.
    (5) Consistency period. The consistency period is the period 
described in section 338(h)(4)(A) unless extended pursuant to 
Sec. 1.338-8(j)(1).
    (6) Deemed asset sale. The deemed asset sale is the transaction 
described in Sec. 1.338-1(a)(1) that is deemed to occur for purposes of 
subtitle A of the Internal Revenue Code if a section 338 election is 
made.
    (7) Deemed sale tax consequences. Deemed sale tax consequences  
refers to, in the aggregate, the Federal income tax consequences 
(generally, the income, gain, deduction, and loss) of the deemed asset 
sale. Deemed sale tax consequences also refers to the Federal income 
tax consequences of the transfer of a particular asset in the deemed 
asset sale.
    (8) Deemed sale return. The deemed sale return is the return on 
which target's deemed sale tax consequences are reported that does not 
include any other items of target. Target files a deemed sale return 
when a section 338 election (but not a section 338(h)(10) election) is 
filed for target and target is a member of a selling group (defined in 
paragraph (c)(16) of this section) that files a consolidated return for 
the period that includes the acquisition date. See Sec. 1.338-10. If 
target is an S corporation for the period that ends on the day before 
the acquisition date and a section 338 election (but not a section 
338(h)(10) election) is filed for target, see Sec. 1.338-10(a)(3).
    (9) Domestic corporation. A domestic corporation is a corporation--
    (i) That is domestic within the meaning of section 7701(a)(4) or 
that is treated as domestic for purposes of subtitle A of the Internal 
Revenue Code (e.g., to which an election under section 953(d) or 
1504(d) applies); and
    (ii) That is not a DISC, a corporation described in section 
1248(e), or a corporation to which an election under section 936 
applies.
    (10) Old target's final return. Old target's final return is the 
income tax return of old target for the taxable year ending at the 
close of the acquisition date that includes the deemed sale tax

[[Page 9934]]

consequences. However, if a deemed sale return is filed for old target, 
the deemed sale return is considered old target's final return.
    (11) Purchasing corporation. The term purchasing corporation has 
the same meaning as in section 338(d)(1). The purchasing corporation 
may also be referred to as purchaser. Unless otherwise provided, any 
reference to the purchasing corporation is a reference to all members 
of the affiliated group of which the purchasing corporation is a 
member. See sections 338(h)(5) and (8). Also, unless otherwise 
provided, any reference to the purchasing corporation is, with respect 
to a deemed purchase of stock under section 338(a)(2), a reference to 
new target with respect to its own deemed purchase of stock in another 
target.
    (12) Qualified stock purchase. The term qualified stock purchase 
has the same meaning as in section 338(d)(3).
    (13) Related persons. Two persons are related if stock in a 
corporation owned by one of the persons would be attributed under 
section 318(a) (other than section 318(a)(4)) to the other.
    (14) Section 338 election. A section 338 election is an election to 
apply section 338(a) to target. A section 338 election is made by 
filing a statement of section 338 election pursuant to paragraph (d) of 
this section. The form on which this statement is filed is referred to 
in the regulations under section 338 as the Form 8023, ``Elections 
Under Section 338 For Corporations Making Qualified Stock Purchases.''
    (15) Section 338(h)(10) election. A section 338(h)(10) election is 
an election to apply section 338(h)(10) to target. A section 338(h)(10) 
election is made by making a joint election for target under 
Sec. 1.338(h)(10)-1 on Form 8023.
    (16) Selling group. The selling group is the affiliated group (as 
defined in section 1504) eligible to file a consolidated return that 
includes target for the taxable period in which the acquisition date 
occurs. However, a selling group is not an affiliated group of which 
target is the common parent on the acquisition date.
    (17) Target; old target; new target. Target is the target 
corporation as defined in section 338(d)(2). Old target refers to 
target for periods ending on or before the close of target's 
acquisition date. New target refers to target for subsequent periods.
    (18) Target affiliate. The term target affiliate has the same 
meaning as in section 338(h)(6) (applied without section 
338(h)(6)(B)(i)). Thus, a corporation described in section 
338(h)(6)(B)(i) is considered a target affiliate for all purposes of 
section 338. If a target affiliate is acquired in a qualified stock 
purchase, it is also a target.
    (19) 12-month acquisition period. The 12-month acquisition period 
is the period described in section 338(h)(1), unless extended pursuant 
to Sec. 1.338-8(j)(2).
    (d) Time and manner of making election. The purchasing corporation 
makes a section 338 election for target by filing a statement of 
section 338 election on Form 8023 in accordance with the instructions 
to the form. The section 338 election must be made not later than the 
15th day of the 9th month beginning after the month in which the 
acquisition date occurs. A section 338 election is irrevocable. See 
Sec. 1.338(h)(10)-1(c)(2) for section 338(h)(10) elections.
    (e) Special rules for foreign corporations or DISCs--(1) Elections 
by certain foreign purchasing corporations--(i) General rule. A 
qualifying foreign purchasing corporation is not required to file a 
statement of section 338 election for a qualifying foreign target 
before the earlier of 3 years after the acquisition date and the 180th 
day after the close of the purchasing corporation's taxable year within 
which a triggering event occurs.
    (ii) Qualifying foreign purchasing corporation. A purchasing 
corporation is a qualifying foreign purchasing corporation only if, 
during the acquisition period of a qualifying foreign target, all the 
corporations in the purchasing corporation's affiliated group are 
foreign corporations that are not subject to United States tax.
    (iii) Qualifying foreign target. A target is a qualifying foreign 
target only if target and its target affiliates are foreign 
corporations that, during target's acquisition period, are not subject 
to United States tax (and will not become subject to United States tax 
during such period because of a section 338 election). A target 
affiliate is taken into account for purposes of the preceding sentence 
only if, during target's 12-month acquisition period, it is or becomes 
a member of the affiliated group that includes the purchasing 
corporation.
    (iv) Triggering event. A triggering event occurs in the taxable 
year of the qualifying foreign purchasing corporation in which either 
that corporation or any corporation in its affiliated group becomes 
subject to United States tax.
    (v) Subject to United States tax. For purposes of this paragraph 
(e)(1), a foreign corporation is considered subject to United States 
tax--
    (A) For the taxable year for which that corporation is required 
under Sec. 1.6012-2(g) (other than Sec. 1.6012-2(g)(2)(i)(B)(2)) to 
file a United States income tax return; or
    (B) For the period during which that corporation is a controlled 
foreign corporation, a passive foreign investment company for which an 
election under section 1295 is in effect, a foreign investment company, 
or a foreign corporation the stock ownership of which is described in 
section 552(a)(2).
    (2) Acquisition period. For purposes of this paragraph (e), the 
term acquisition period means the period beginning on the first day of 
the 12-month acquisition period and ending on the acquisition date.
    (3) Statement of section 338 election may be filed by United States 
shareholders in certain cases. The United States shareholders (as 
defined in section 951(b)) of a foreign purchasing corporation that is 
a controlled foreign corporation (as defined in section 957 (taking 
into account section 953(c))) may file a statement of section 338 
election on behalf of the purchasing corporation if the purchasing 
corporation is not required under Sec. 1.6012-2(g) (other than 
Sec. 1.6012-2(g)(2)(i)(B)(2)) to file a United States income tax return 
for its taxable year that includes the acquisition date. Form 8023 must 
be filed as described in the form and its instructions and also must be 
attached to the Form 5471, ``Information Returns Of U.S. Persons With 
Respect To Certain Foreign Corporations,'' filed with respect to the 
purchasing corporation by each United States shareholder for the 
purchasing corporation's taxable year that includes the acquisition 
date (or, if paragraph (e)(1)(i) of this section applies to the 
election, for the purchasing corporation's taxable year within which it 
becomes a controlled foreign corporation). The provisions of 
Sec. 1.964-1(c) (including Sec. 1.964-1(c)(7)) do not apply to an 
election made by the United States shareholders.
    (4) Notice requirement for U.S. persons holding stock in foreign 
target--(i) General rule. If a target subject to a section 338 election 
was a controlled foreign corporation, a passive foreign investment 
company, or a foreign personal holding company at any time during the 
portion of its taxable year that ends on its acquisition date, the 
purchasing corporation must deliver written notice of the election (and 
a copy of Form 8023, its attachments and instructions) to--

[[Page 9935]]

    (A) Each U.S. person (other than a member of the affiliated group 
of which the purchasing corporation is a member (the purchasing group 
member)) that, on the acquisition date of the foreign target, holds 
stock in the foreign target; and
    (B) Each U.S. person (other than a purchasing group member) that 
sells stock in the foreign target to a purchasing group member during 
the foreign target's 12-month acquisition period.
    (ii) Limitation. The notice requirement of this paragraph (e)(4) 
applies only where the section 338 election for the foreign target 
affects income, gain, loss, deduction, or credit of the U.S. person 
described in paragraph (e)(4)(i) of this section under section 551, 
951, 1248, or 1293.
    (iii) Form of notice. The notice to U.S. persons must be identified 
prominently as a notice of section 338 election and must--
    (A) Contain the name, address, and employer identification number 
(if any) of, and the country (and, if relevant, the lesser political 
subdivision) under the laws of which are organized the purchasing 
corporation and the relevant target (i.e., the target the stock of 
which the particular U.S. person held or sold under the circumstances 
described in paragraph (e)(4)(i) of this section);
    (B) Identify those corporations as the purchasing corporation and 
the foreign target, respectively; and
    (C) Contain the following declaration (or a substantially similar 
declaration):

    THIS DOCUMENT SERVES AS NOTICE OF AN ELECTION UNDER SECTION 338 
FOR THE ABOVE CITED FOREIGN TARGET THE STOCK OF WHICH YOU EITHER 
HELD OR SOLD UNDER THE CIRCUMSTANCES DESCRIBED IN TREASURY 
REGULATIONS SECTION 1.338-2(e)(4). FOR 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's merging downstream into target, liquidating, or otherwise disposing 
of the target stock following the purported qualified stock purchase.
    (2) Purchase. The term purchase has the same meaning as in section 
338(h)(3). Stock in a target (or target affiliate) may be considered 
purchased if, under general principles of tax law, the purchasing 
corporation is considered to own stock of the target (or target 
affiliate) meeting the requirements of section 1504(a)(2), 
notwithstanding that no amount may be paid for (or allocated to) the 
stock.
    (3) Acquisitions of stock from related corporations--(i) In 
general. Stock acquired by a purchasing corporation from a related 
corporation (R) is generally not considered acquired by purchase. See 
section 338(h)(3)(A)(iii).
    (ii) Time for testing relationship. For purposes of section 
338(h)(3)(A)(iii), a purchasing corporation is treated as related to 
another person if the relationship specified in section 
338(h)(3)(A)(iii) exists--
    (A) In the case of a single transaction, immediately after the 
purchase of target stock;
    (B) In the case of a series of acquisitions otherwise constituting 
a qualified stock purchase within the meaning of section 338(d)(3), 
immediately after the last acquisition in such series; and
    (C) In the case of a series of transactions effected pursuant to an 
integrated plan to dispose of target stock, immediately after the last 
transaction in such series.
    (iii) Cases where section 338(h)(3)(C) applies--acquisitions 
treated as purchases. If section 338(h)(3)(C) applies and the 
purchasing corporation is treated as acquiring stock by purchase from 
R, solely for purposes of determining when the stock is considered 
acquired, target stock acquired from R is considered to have been 
acquired by the purchasing corporation on the day on which the 
purchasing corporation is first considered to own that stock under 
section 318(a) (other than section 318(a)(4)).
    (iv) Examples. The following examples illustrate this paragraph 
(b)(3):

    Example 1. (i) S is the parent of a group of corporations that 
are engaged in various businesses. Prior to January 1, Year 1, S 
decided to discontinue its involvement in one line of business. To 
accomplish this, S forms a new corporation, Newco, with a nominal 
amount of cash. Shortly thereafter, on January 1, Year 1, S 
transfers all the stock of the subsidiary conducting the unwanted 
business (T) to Newco in exchange for 100 shares of Newco common 
stock and a Newco promissory note. Prior to January 1, Year 1, S and 
Underwriter (U) had entered into a binding agreement pursuant to 
which U would purchase 60 shares of Newco common stock from S and 
then sell those shares in an Initial Public Offering (IPO). On 
January 6, Year 1, the IPO closes.
    (ii) Newco's acquisition of T stock is one of a series of 
transactions undertaken pursuant to one integrated plan. The series 
of transactions ends with the closing of the IPO and the transfer of 
all the shares of stock in accordance with the agreements. 
Immediately after the last transaction effected pursuant to the 
plan, S owns 40 percent of Newco, which does not give rise to a 
relationship described in section 338(h)(3)(A)(iii). See Sec. 1.338-
2(b)(3)(ii)(C). Accordingly, S and Newco are not related for 
purposes of section 338(h)(3)(A)(iii).
    (iii) Further, because Newco's basis in the T stock is not 
determined by reference to S's basis in the T stock and because the 
transaction is not an exchange to which section 351, 354, 355, or 
356 applies, Newco's acquisition of the T stock is a

[[Page 9936]]

purchase within the meaning of section 338(h)(3).
    Example 2. (i) On January 1 of Year 1, P purchases 75 percent in 
value of the R stock. On that date, R owns 4 of the 100 shares of T 
stock. On June 1 of Year 1, R acquires an additional 16 shares of T 
stock. On December 1 of Year 1, P purchases 70 shares of T stock 
from an unrelated person and 12 of the 20 shares of T stock held by 
R.
    (ii) Of the 12 shares of T stock purchased by P from R on 
December 1 of Year 1, 3 of those shares are deemed to have been 
acquired by P on January 1 of Year 1, the date on which 3 of the 4 
shares of T stock held by R on that date were first considered owned 
by P under section 318(a)(2)(C) (i.e., 4  x  .75). The remaining 9 
shares of T stock purchased by P from R on December 1 of Year 1 are 
deemed to have been acquired by P on June 1 of Year 1, the date on 
which an additional 12 of the 20 shares of T stock owned by R on 
that date were first considered owned by P under section 
318(a)(2)(C) (i.e., (20  x  .75)-3). Because stock acquisitions by P 
sufficient for a qualified stock purchase of T occur within a 12-
month period (i.e., 3 shares constructively on January 1 of Year 1, 
9 shares constructively on June 1 of Year 1, and 70 shares actually 
on December 1 of Year 1), a qualified stock purchase is made on 
December 1 of Year 1.
    Example 3. (i) On February 1 of Year 1, P acquires 25 percent in 
value of the R stock from B (the sole shareholder of P). That R 
stock is not acquired by purchase. See section 338(h)(3)(A)(iii). On 
that date, R owns 4 of the 100 shares of T stock. On June 1 of Year 
1, P purchases an additional 25 percent in value of the R stock, and 
on January 1 of Year 2, P purchases another 25 percent in value of 
the R stock. On June 1 of Year 2, R acquires an additional 16 shares 
of the T stock. On December 1 of Year 2, P purchases 68 shares of 
the T stock from an unrelated person and 12 of the 20 shares of the 
T stock held by R.
    (ii) Of the 12 shares of the T stock purchased by P from R on 
December 1 of Year 2, 2 of those shares are deemed to have been 
acquired by P on June 1 of Year 1, the date on which 2 of the 4 
shares of the T stock held by R on that date were first considered 
owned by P under section 318(a)(2)(C) (i.e., 4  x  .5). For purposes 
of this attribution, the R stock need not be acquired by P by 
purchase. See section 338(h)(1). (By contrast, the acquisition of 
the T stock by P from R does not qualify as a purchase unless P has 
acquired at least 50 percent in value of the R stock by purchase. 
Section 338(h)(3)(C)(i).) Of the remaining 10 shares of the T stock 
purchased by P from R on December 1 of Year 2, 1 of those shares is 
deemed to have been acquired by P on January 1 of Year 2, the date 
on which an additional 1 share of the 4 shares of the T stock held 
by R on that date was first considered owned by P under section 
318(a)(2)(C) (i.e., (4  x  .75)-2). The remaining 9 shares of the T 
stock purchased by P from R on December 1 of Year 2, are deemed to 
have been acquired by P on June 1 of Year 2, the date on which an 
additional 12 shares of the T stock held by R on that date were 
first considered owned by P under section 318(a)(2)(C) (i.e., (20 
x  .75)-3). Because a qualified stock purchase of T by P is made on 
December 1 of Year 2 only if all 12 shares of the T stock purchased 
by P from R on that date are considered acquired during a 12-month 
period ending on that date (so that, in conjunction with the 68 
shares of the T stock P purchased on that date from the unrelated 
person, 80 of T's 100 shares are acquired by P during a 12-month 
period) and because 2 of those 12 shares are considered to have been 
acquired by P more than 12 months before December 1 of Year 2 (i.e., 
on June 1 of Year 1), a qualified stock purchase is not made. (Under 
Sec. 1.338-8(j)(2), for purposes of applying the consistency rules, 
P is treated as making a qualified stock purchase of T if, pursuant 
to an arrangement, P purchases T stock satisfying the requirements 
of section 1504(a)(2) over a period of more than 12 months.)
    Example 4. Assume the same facts as in Example 3, except that on 
February 1 of Year 1, P acquires 25 percent in value of the R stock 
by purchase. The result is the same as in Example 3.

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

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

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

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

[[Page 9937]]

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

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

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

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

    Example. (i) Facts. P, T, and X are domestic corporations. T and 
X each operate a trade or business. A and K, individuals unrelated 
to P, own 85 and 15 percent, respectively, of the stock of T. P owns 
all of the stock of X. The total adjusted basis of T's property 
exceeds the sum of T's liabilities plus the amount of liabilities to 
which T's property is subject. P purchases all of A's T stock for 
cash in a qualified stock purchase. P does not make an election 
under section 338(g) with respect to its acquisition of T stock. 
Shortly after the acquisition date, and as part of the same plan, T 
merges under applicable state law into X in a transaction that, but 
for the question of continuity of interest, satisfies all the 
requirements of section 368(a)(1)(A). In the merger, all of T's 
assets are transferred to X. P and K receive X stock in exchange for 
their T stock. P intends to retain the stock of X indefinitely.
    (ii) Status of transfer as a reorganization. By virtue of 
section 338, for the purpose of determining whether the continuity 
of interest requirement of Sec. 1.368-1(b) is satisfied, P's T stock 
acquired in the qualified stock purchase represents an interest on 
the part of a person who was an owner of T's business enterprise 
prior to the transfer that can be continued in a reorganization 
through P's continuing ownership of X. Thus, the continuity of 
interest requirement is satisfied and the merger of T into X is a 
reorganization within the meaning of section 368(a)(1)(A). Moreover, 
by virtue of section 338, the requirement of section 368(a)(1)(D) 
that a target shareholder control the transferee immediately after 
the transfer is satisfied because P controls X immediately after the 
transfer. In addition, all of T's assets are transferred to X in the 
merger and P and K

[[Page 9938]]

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


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

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

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

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

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

    (d) Liabilities of old target--(1) In general. In general, the 
liabilities of old target are measured as of the beginning of the day 
after the acquisition date. (But see Sec. 1.338-1(d) (regarding certain 
transactions on the acquisition date).) In order to be taken into 
account in ADSP, a liability must be a liability of target that is 
properly taken into account in amount realized under general principles 
of tax law that would apply if old target had sold its assets to an 
unrelated person for consideration that included the discharge of its 
liabilities. See Sec. 1.1001-2(a). Such liabilities may include 
liabilities for the tax consequences resulting from the deemed sale.
    (2) Time and amount of liabilities. The time for taking into 
account liabilities of old target in determining

[[Page 9939]]

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

    Example 1. One class.  (i) On July 1 of Year 1, T's only asset 
is an item of section 1245 property with an adjusted basis to T of 
$50,400, a recomputed basis of $80,000, and a fair market value of 
$100,000. P purchases all of the T stock for $75,000, which also 
equals the amount realized for the stock determined as if the 
selling shareholder(s) were required to use old target's accounting 
methods and characteristics.
    (ii) ADSP is determined as follows (for purposes of this section 
(g), G is the grossed-up amount realized on the sale to P of P's 
recently purchased T stock, L is T's liabilities other than T's tax 
liability for the deemed sale tax consequences, TR is the 
applicable tax rate, and B is the adjusted basis of the asset deemed 
sold):
    ADSP = G + L + TR `` (ADSP-B)
    ADSP = ($75,000/1) + $0 + .34  x  (ADSP - $50,400)
    ADSP = $75,000 + .34ADSP - $17,136 .66ADSP = $57,864
    ADSP = $87,672.72
    (iii) Because ADSP for T ($87,672.72) does not exceed the fair 
market value of T's asset ($100,000), a Class V asset, T's entire 
ADSP is allocated to that asset. Thus, T's deemed sale results in 
$37,272.72 of taxable income (consisting of $29,600 of ordinary 
income and $7,672.72 of capital gain).
    (iv) The facts are the same as in paragraph (i) of this Example 
1, except that on July 1 of Year 1, P purchases only 80 of the 100 
shares of T stock for $60,000. The grossed-up amount realized on the 
sale to P of P's recently purchased T stock (G) is $75,000 
($60,000/.8). Consequently, ADSP and the deemed sale tax 
consequences are the same as in paragraphs (ii) and (iii) of this 
Example 1.
    (v) The facts are the same as in paragraph (i) of this Example 
1, except that T also has goodwill (a Class VII asset) with an 
appraised value of $10,000. The results are the same as in 
paragraphs (ii) and (iii) of this Example 1. Because ADSP does not 
exceed the fair market value of the Class V asset, no amount is 
allocated to the Class VII asset (goodwill).
    Example 2. More than one class. (i) P purchases all of the T 
stock for $140,000, which also equals the amount realized for the 
stock determined as if the selling shareholder(s) were required to 
use old target's accounting methods and characteristics. On July 1 
of Year 1, T has liabilities (not including the tax liability for 
the deemed sale tax consequences) of $50,000, cash (a Class I asset) 
of $10,000, actively traded securities (a Class II asset) with a 
basis of $4,000 and a fair market value of $10,000, goodwill (a 
Class VII asset) with a basis of $3,000, and the following Class V 
assets:

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

    (ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to 
the cash and $10,000 to the actively traded securities. The amount 
allocated to an asset (other than a Class VII asset) cannot exceed 
its fair market value (however, the fair market value of any 
property subject to nonrecourse indebtedness is treated as being not 
less than the amount of such indebtedness; see Sec. 1.338-6(a)(2)). 
See Sec. 1.338-6(c)(1) (relating to fair market value limitation).
    (iii) The portion of ADSP allocable to the Class V assets is 
preliminarily determined as follows (in the formula, the amount 
allocated to the Class I assets is referred to as I and the amount 
allocated to the Class II assets as II):
    ADSPV = (G-(I + II)) + L+ TR  x  [(II - 
BII) + (ADSPV - BV)]
    ADSPV = ($140,000 - ($10,000 + $10,000)) + $50,000 + 
.34  x  [($10,000 - $4,000) + (ADSPV - ($5,000 + $10,000 
+ $5,000 + $10,000))]
    ADSPV = $161,840 + .34ADSPV
    .66 ADSPV = $161,840
    ADSPV = $245,212.12
    (iv) Because, under the preliminary calculations of ADSP, the 
amount to be allocated to the Class I, II, III, IV, V, and VI assets 
does not exceed their aggregate fair market value, no ADSP amount is 
allocated to goodwill. Accordingly, the deemed sale of the goodwill 
results in a capital loss of $3,000. The portion of ADSP allocable 
to the Class V assets is finally determined by taking into account 
this loss as follows:
    ADSPV = (G - (I + II)) + L + T  R  x  [(II 
- BII) + (ADSPV - BV) + (ADSPVII - 
B VII)]
    ADSPV = ($140,000 - ($10,000 + $10,000))+ $50,000 + 
.34  x  [($10,000 - $4,000) + (ADSPV - $30,000) + ($0 - 
$3,000)]
    ADSPV = $160,820 + .34ADSPV
    .66 ADSPV = $160,820
    ADSPV = $243,666.67
    (v) The allocation of ADSPV among the Class V assets 
is in proportion to their fair market values, as follows:

[[Page 9940]]



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

    Example 3. More than one class. (i) The facts are the same as in 
Example 2, except that P purchases the T stock for $150,000, rather 
than $140,000. The amount realized for the stock determined as if 
the selling shareholder(s) were required to use old target's 
accounting methods and characteristics is also $150,000.
    (ii) As in Example 2, ADSP exceeds $20,000. Thus, $10,000 of 
ADSP is allocated to the cash and $10,000 to the actively traded 
securities.
    (iii) The portion of ADSP allocable to the Class V assets as 
preliminarily determined under the formula set forth in paragraph 
(iii) of Example 2 is $260,363.64. The amount allocated to the Class 
V assets cannot exceed their aggregate fair market value ($250,000). 
Thus, preliminarily, the ADSP amount allocated to Class V assets is 
$250,000.
    (iv) Based on the preliminary allocation, the ADSP is determined 
as follows (in the formula, the amount allocated to the Class I 
assets is referred to as I, the amount allocated to the Class II 
assets as II, and the amount allocated to the Class V assets as V):
    ADSP = G + L + TR  x  [(II - BII) + (V - 
BV) + (ADSP - (I + II + V + BVII))]
    ADSP = $150,000 + $50,000 + .34  x  [($10,000 - $4,000) + 
($250,000 - $30,000) + (ADSP - ($10,000 + $10,000 + $250,000 + 
$3,000))]
    ADSP = $200,000 + .34ADSP - $15,980
    .66ADSP = $184,020
    ADSP = $278,818.18
    (v) Because ADSP as determined exceeds the aggregate fair market 
value of the Class I, II, III, IV, V, and VI assets, the $250,000 
amount preliminarily allocated to the Class V assets is appropriate. 
Thus, the amount of ADSP allocated to Class V assets equals their 
aggregate fair market value ($250,000), and the allocated ADSP 
amount for each Class V asset is its fair market value. Further, 
because there are no Class VI assets, the allocable ADSP amount for 
the Class VII asset (goodwill) is $8,818.18 (the excess of ADSP over 
the aggregate ADSP amounts for the Class I, II, III, IV, V and VI 
assets).
    Example 4. Amount allocated to T1 stock. (i) The facts are the 
same as in Example 2, except that T owns all of the T1 stock 
(instead of the building), and T1's only asset is the building. The 
T1 stock and the building each have a fair market value of $50,000, 
and the building has a basis of $10,000. A section 338 election is 
made for T1 (as well as T), and T1 has no liabilities other than the 
tax liability for the deemed sale tax consequences. T is the common 
parent of a consolidated group filing a final consolidated return 
described in Sec. 1.338-10(a)(1).
    (ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to 
the cash and $10,000 to the actively traded securities.
    (iii) Because T does not recognize any gain on the deemed sale 
of the T1 stock under paragraph (h)(2) of this section, appropriate 
adjustments must be made to reflect accurately the fair market value 
of the T and T1 assets in determining the allocation of ADSP among 
T's Class V assets (including the T1 stock). In preliminarily 
calculating ADSPV in this case, the T1 stock can be 
disregarded and, because T owns all of the T1 stock, the T1 asset 
can be treated as a T asset. Under this assumption, ADSPV 
is $243,666.67. See paragraph (iv) of Example 2.
    (iv) Because the portion of the preliminary ADSP allocable to 
Class V assets ($243,666.67) does not exceed their fair market value 
($250,000), no amount is allocated to Class VII assets for T. 
Further, this amount ($243,666.67) is allocated among T's Class V 
assets in proportion to their fair market values. See paragraph (v) 
of Example 2. Tentatively, $48,733.34 of this amount is allocated to 
the T1 stock.
    (v) The amount tentatively allocated to the T1 stock, however, 
reflects the tax incurred on the deemed sale of the T1 asset equal 
to $13,169.34 (.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.
    (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

[[Page 9941]]

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). Section 1.338-9(b). For 
purposes of sections 901 through 908, the source and foreign tax 
credit limitation basket of $25 of the recharacterized gain on the 
deemed sale of the FT1 stock is determined under section 338(h)(16).


Sec. 1.338-5  Adjusted grossed-up basis.

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

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

[[Page 9942]]

treated as incurred and taken into account in basis until that time. 
The incurrence of the liability in Year 5 under the economic 
performance rules is an increase in the amount of liabilities 
properly taken into account in basis and results in the 
redetermination of AGUB. (Respecting ADSP, compare Sec. 1.461-
4(d)(5), which provides that economic performance occurs for old T 
as the amount of the liability is properly taken into account in 
amount realized on the deemed asset sale. Thus ADSP is not 
redetermined when new T satisfies the economic performance 
requirements.)

    (c) Grossed-up basis of recently purchased stock. The purchasing 
corporation's grossed-up basis of recently purchased target stock (as 
defined in section 338(b)(6)(A)) is an amount equal to--
    (1) The purchasing corporation's basis in recently purchased target 
stock at the beginning of the day after the acquisition date determined 
without regard to the acquisition costs taken into account in paragraph 
(c)(3) of this section;
    (2) Multiplied by a fraction, the numerator of which is 100 minus 
the number that is the percentage of target stock (by value, determined 
on the acquisition date) attributable to the purchasing corporation's 
nonrecently purchased target stock, and the denominator of which is the 
number equal to the percentage of target stock (by value, determined on 
the acquisition date) attributable to the purchasing corporation's 
recently purchased target stock;
    (3) Plus the acquisition costs the purchasing corporation incurred 
in connection with its purchase of the recently purchased stock that 
are capitalized in the basis of such stock (e.g., brokerage commissions 
and any similar costs incurred by the purchasing corporation to acquire 
the stock).
    (d) Basis of nonrecently purchased stock; gain recognition 
election--(1) No gain recognition election. In the absence of a gain 
recognition election under section 338(b)(3) and this section, the 
purchasing corporation retains its basis in the nonrecently purchased 
stock.
    (2) Procedure for making gain recognition election. A gain 
recognition election may be made for nonrecently purchased stock of 
target (or a target affiliate) only if a section 338 election is made 
for target (or the target affiliate). The gain recognition election is 
made by attaching a gain recognition statement to a timely filed Form 
8023 for target. The gain recognition statement must contain the 
information specified in the form and its instructions. The gain 
recognition election is irrevocable. If a section 338(h)(10) election 
is made for target, see Sec. 1.338(h)(10)-1(d)(1) (providing that the 
purchasing corporation is automatically deemed to have made a gain 
recognition election for its nonrecently purchased T stock).
    (3) Effect of gain recognition election--(i) In general. If the 
purchasing corporation makes a gain recognition election, then for all 
purposes of the Internal Revenue Code--
    (A) The purchasing corporation is treated as if it sold on the 
acquisition date the nonrecently purchased target stock for the basis 
amount determined under paragraph (d)(3)(ii) of this section; and
    (B) The purchasing corporation's basis on the acquisition date in 
nonrecently purchased target stock immediately following the deemed 
sale in paragraph (d)(3)(i)(A) of this section is the basis amount.
    (ii) Basis amount. The basis amount is equal to the amount in 
paragraph (c)(1) of this section (the purchasing corporation's basis in 
recently purchased target stock at the beginning of the day after the 
acquisition date determined without regard to the acquisition costs 
taken into account in paragraph (c)(3) of this section) multiplied by a 
fraction the numerator of which is the percentage of target stock (by 
value, determined on the acquisition date) attributable to the 
purchasing corporation's nonrecently purchased target stock and the 
denominator of which is 100 percent minus the numerator amount. Thus, 
if target has a single class of outstanding stock, the purchasing 
corporation's basis in each share of nonrecently purchased target stock 
after the gain recognition election is equal to the average price per 
share of the purchasing corporation's recently purchased target stock.
    (iii) Losses not recognized. Only gains (unreduced by losses) on 
the nonrecently purchased target stock are recognized.
    (iv) Stock subject to election. The gain recognition election 
applies to--
    (A) All nonrecently purchased target stock; and
    (B) Any nonrecently purchased stock in a target affiliate having 
the same acquisition date as target if such target affiliate stock is 
held by the purchasing corporation on such date.
    (e) Liabilities of new target--(1) In general. The liabilities of 
new target are the liabilities of target as of the beginning of the day 
after the acquisition date (but see Sec. 1.338-1(d) (regarding certain 
transactions on the acquisition date)). In order to be taken into 
account in AGUB, a liability must be a liability of target that is 
properly taken into account in basis under general principles of tax 
law that would apply if new target had acquired its assets from an 
unrelated person for consideration that included discharge of the 
liabilities of that unrelated person. Such liabilities may include 
liabilities for the tax consequences resulting from the deemed sale.
    (2) Time and amount of liabilities. The time for taking into 
account liabilities of old target in determining AGUB and the amount of 
the liabilities taken into account is determined as if new target had 
acquired its assets from an unrelated person for consideration that 
included the discharge of its liabilities.
    (3) Interaction with deemed sale tax consequences. In general, see 
Sec. 1.338-4(e). Although ADSP and AGUB are not necessarily linked, if 
an increase in the amount realized for recently purchased stock of 
target is taken into account after the acquisition date, and if the tax 
on the deemed sale tax consequences is a liability of target, any 
increase in that liability is also taken into account in redetermining 
AGUB.
    (f) Adjustments by the Internal Revenue Service. In connection with 
the examination of a return, the Commissioner may increase (or 
decrease) AGUB under the authority of section 338(b)(2) and allocate 
such amounts to target's assets under the authority of section 
338(b)(5) so that AGUB and the basis of target's assets properly 
reflect the cost to the purchasing corporation of its interest in 
target's assets. Such items may include distributions from target to 
the purchasing corporation, capital contributions from the purchasing 
corporation to target during the 12-month acquisition period, or 
acquisitions of target stock by the purchasing corporation after the 
acquisition date from minority shareholders. See also Sec. 1.338-1(d) 
(regarding certain transactions on the acquisition date).
    (g) Examples. The following examples illustrate this section. For 
purposes of the examples in this paragraph (g), T has no liabilities 
other than the tax liability for the deemed sale tax consequences, T 
shareholders incur no costs in selling the T stock, and P incurs no 
costs in acquiring the T stock. The examples are as follows:

    Example 1. (i) Before July 1 of Year 1, P purchases 10 of the 
100 shares of T stock for $5,000. On July 1 of Year 2, P purchases 
80 shares of T stock for $60,000 and makes a section 338 election 
for T. As of July 1 of Year 2, T's only asset is raw land with an 
adjusted basis to T of $50,400 and a fair market value of $100,000. 
T has no loss or tax credit carryovers to Year 2. T's marginal

[[Page 9943]]

tax rate for any ordinary income or net capital gain resulting from 
the deemed asset sale is 34 percent. The 10 shares purchased before 
July 1 of Year 1 constitute nonrecently purchased T stock with 
respect to P's qualified stock purchase of T stock on July 1 of Year 
2.
    (ii) The ADSP formula as applied to these facts is the same as 
in Sec. 1.338-4(g) Example 1. Accordingly, the ADSP for T is 
$87,672.72. The existence of nonrecently purchased T stock is 
irrelevant for purposes of the ADSP formula, because that formula 
treats P's nonrecently purchased T stock in the same manner as T 
stock not held by P.
    (iii) The total tax liability resulting from T's deemed asset 
sale, as calculated under the ADSP formula, is $12,672.72.
    (iv) If P does not make a gain recognition election, the AGUB of 
new T's assets is $85,172.72, determined as follows (In the 
following formula below, GRP is the grossed-up basis in P's recently 
purchased T stock, BNP is P's basis in nonrecently purchased T 
stock, L is T's liabilities, and X is P's acquisition costs for the 
recently purchased T stock):

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

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

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

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

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

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


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

    (a) Scope--(1) In general. This section prescribes rules for 
allocating ADSP and AGUB among the acquisition date assets of a target 
for which a section 338 election is made.
    (2) Fair market value--(i) In general. Generally, the fair market 
value of an asset is its gross fair market value (i.e., fair market 
value determined without regard to mortgages, liens, pledges, or other 
liabilities). However, for purposes of determining the amount of old 
target's deemed sale tax consequences, the fair market value of any 
property subject to a nonrecourse indebtedness will be treated as being 
not less than the amount of such indebtedness. (For purposes of the 
preceding sentence, a liability that was incurred because of the 
acquisition of the property is disregarded to the extent that such 
liability was not taken into account in determining old target's basis 
in such property.)
    (ii) Transaction costs. Transaction costs are not taken into 
account in allocating ADSP or AGUB to assets in the deemed sale (except 
indirectly through their effect on the total ADSP or AGUB to be 
allocated).
    (iii) Internal Revenue Service authority. In connection with the 
examination of a return, the Internal Revenue Service may challenge the 
taxpayer's determination of the fair market value of any asset by any 
appropriate method and take into account all factors, including any 
lack of adverse tax interests between the parties.
    (b) General rule for allocating ADSP and AGUB--(1) Reduction in the 
amount of consideration for Class I assets. Both ADSP and AGUB, in the 
respective allocation of each, are first reduced by the amount of Class 
I assets. Class I assets are cash and general deposit accounts 
(including savings and checking accounts) other than certificates of 
deposit held in banks, savings and loan associations, and other 
depository institutions. If the amount of Class I assets exceeds AGUB, 
new target will immediately realize ordinary income in an amount equal 
to such excess. The amount of ADSP or AGUB remaining after the 
reduction is to be allocated to the remaining acquisition date assets.
    (2) Other assets--(i) In general. Subject to the limitations and 
other rules of paragraph (c) of this section, ADSP and AGUB (as reduced 
by the amount of Class I assets) are allocated among Class II 
acquisition date assets of target in proportion to the fair market 
values of such Class II assets at such time, then among Class III 
assets so held in such proportion, then among Class IV assets so held 
in such proportion, then among Class V assets so held in such 
proportion, then among Class VI assets so held in such proportion, and 
finally to Class VII assets. If an asset is described below as 
includible in more than one class, then it is included in such class 
with the lower or lowest class number (for instance, Class III has a 
lower class number than Class IV).
    (ii) Class II assets. Class II assets are actively traded personal 
property within the meaning of section 1092(d)(1) and Sec. 1.1092(d)-1 
(determined without regard to section 1092(d)(3)). In addition, Class 
II assets include certificates of deposit and foreign currency even if 
they are not actively traded personal property. Class II assets do not 
include stock of target affiliates, whether or not of a class that is 
actively traded, other than actively traded stock described in section 
1504(a)(4). Examples of Class II assets include U.S. government 
securities and publicly traded stock.
    (iii) Class III assets. Class III assets are assets that the 
taxpayer marks to market at least annually for Federal income tax 
purposes and debt instruments (including accounts receivable). However, 
Class III assets do not include--
    (A) Debt instruments issued by persons related at the beginning of 
the day following the acquisition date to the target under section 
267(b) or 707;
    (B) Contingent debt instruments subject to Sec. 1.1275-4, 
Sec. 1.483-4, or section 988, unless the instrument is subject to the 
non-contingent bond method of Sec. 1.1275-4(b) or is described in 
Sec. 1.988-2(b)(2)(i)(B)(2); and
    (C) Debt instruments convertible into the stock of the issuer or 
other property.
    (iv) Class IV assets. Class IV assets are stock in trade of the 
taxpayer or other property of a kind that would properly be included in 
the inventory of taxpayer if on hand at the close of the taxable year, 
or property held by the taxpayer primarily for sale to customers in the 
ordinary course of its trade or business.
    (v) Class V assets. Class V assets are all assets other than Class 
I, II, III, IV, VI, and VII assets.

[[Page 9944]]

    (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 (see Sec. 601.601(d)(2) of this chapter).
    (c) Certain limitations and other rules for allocation to an 
asset--(1) Allocation not to exceed fair market value. The amount of 
ADSP or AGUB allocated to an asset (other than Class VII assets) cannot 
exceed the fair market value of that asset at the beginning of the day 
after the acquisition date.
    (2) Allocation subject to other rules. The amount of ADSP or AGUB 
allocated to an asset is subject to other provisions of the Internal 
Revenue Code or general principles of tax law in the same manner as if 
such asset were transferred to or acquired from an unrelated person in 
a sale or exchange. For example, if the deemed asset sale is a 
transaction described in section 1056(a) (relating to basis limitation 
for player contracts transferred in connection with the sale of a 
franchise), the amount of AGUB allocated to a contract for the services 
of an athlete cannot exceed the limitation imposed by that section. As 
another example, section 197(f)(5) applies in determining the amount of 
AGUB allocated to an amortizable section 197 intangible resulting from 
an assumption-reinsurance transaction.
    (3) Special rule for allocating AGUB when purchasing corporation 
has nonrecently purchased stock--(i) Scope. This paragraph (c)(3) 
applies if at the beginning of the day after the acquisition date--
    (A) The purchasing corporation holds nonrecently purchased stock 
for which a gain recognition election under section 338(b)(3) and 
Sec. 1.338-5(d) is not made; and
    (B) The hypothetical purchase price determined under paragraph 
(c)(3)(ii) of this section exceeds the AGUB determined under 
Sec. 1.338-5(b).
    (ii) Determination of hypothetical purchase price. Hypothetical 
purchase price is the AGUB that would result if a gain recognition 
election were made.
    (iii) Allocation of AGUB. Subject to the limitations in paragraphs 
(c)(1) and (2) of this section, the portion of AGUB (after reduction by 
the amount of Class I assets) to be allocated to each Class II, III, 
IV, V, VI, and VII asset of target held at the beginning of the day 
after the acquisition date is determined by multiplying--
    (A) The amount that would be allocated to such asset under the 
general rules of this section were AGUB equal to the hypothetical 
purchase price; by
    (B) A fraction, the numerator of which is actual AGUB (after 
reduction by the amount of Class I assets) and the denominator of which 
is the hypothetical purchase price (after reduction by the amount of 
Class I assets).
    (4) Liabilities taken into account in determining amount realized 
on subsequent disposition. In determining the amount realized on a 
subsequent sale or other disposition of property deemed purchased by 
new target, Sec. 1.1001-2(a)(3) shall not apply to any liability that 
was taken into account in AGUB.
    (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 + 1/1).
    (ii) The liabilities of T as of the beginning of the day after 
the acquisition date (including the tax liability for the deemed 
sale tax consequences) that would, under general principles of tax 
law, properly be taken into account at that time, are as follows:

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

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

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

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

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

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

Building.......................................................     $800
Land...........................................................      200
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 tax consequences) that would, under general principles of tax 
law, properly be taken into account at that time, are as follows:

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

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

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

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

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

    (xiii) The amount of ADSP and of AGUB allocable to T1's Class IV 
and VI assets is first reduced by the $50 of cash.
    (xiv) Because the remaining amount of ADSP and of AGUB ($570) is 
an amount which exceeds the fair market value of T1's

[[Page 9945]]

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

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

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

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

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

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

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

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

[[Page 9946]]

past taxable year of old target for purposes of calculation of interest 
due.
    (ii) Carryovers and carrybacks--(A) Loss carryovers to new target 
taxable years. A net operating loss or net capital loss of old target 
may be carried forward to a taxable year of new target, under the 
principles of section 172 or 1212, as applicable, but is allowed as a 
deduction only to the extent of any recognized income of old target for 
such taxable year, as described in paragraph (c)(2)(i) of this section. 
For this purpose, however, taxable years of new target are not taken 
into account in applying the limitations in section 172(b)(1) or 
1212(a)(1)(B) (or other similar limitations). In applying sections 
172(b) and 1212(a)(1), only income, gain, loss, deduction, credit, and 
other amounts of old target are taken into account. Thus, if old target 
has an unexpired net operating loss at the close of its taxable year in 
which the deemed asset sale occurred that could be carried forward to a 
subsequent taxable year, such loss may be carried forward until it is 
absorbed by old target's income.
    (B) Loss carrybacks to taxable years of old target. An ordinary 
loss or capital loss accounted for as a separate item of old target 
under paragraph (c)(2)(i) of this section may be carried back to a 
taxable year of old target under the principles of section 172 or 1212, 
as applicable. For this purpose, taxable years of new target are not 
taken into account in applying the limitations in section 172(b) or 
1212(a) (or other similar limitations).
    (C) Credit carryovers and carrybacks. The principles described in 
paragraphs (c)(2)(ii)(A) and (B) of this section apply to carryovers 
and carrybacks of amounts for purposes of determining the amount of a 
credit allowable under part IV, subchapter A, chapter 1 of the Internal 
Revenue Code. Thus, for example, credit carryovers of old target may 
offset only income tax attributable to items described in paragraph 
(c)(2)(i) of this section.
    (3) Procedure for transactions in which section 338(h)(10) is 
elected. If an election under section 338(h)(10) is made, any changes 
in the deemed sale tax consequences caused by an increase or decrease 
in the ADSP are accounted for in determining the taxable income (or 
other amount) of the member of the selling consolidated group, the 
selling affiliate, or the S corporation shareholders to which such 
income, loss, or other amount is attributable for the taxable year in 
which such increase or decrease is taken into account.
    (d) Special rules for AGUB--(1) Effect of disposition or 
depreciation of acquisition date assets. If an acquisition date asset 
has been disposed of, depreciated, amortized, or depleted by new target 
before an amount is added to the original allocation to the asset, the 
increased amount otherwise allocable to such asset is taken into 
account under general principles of tax law that apply when part of the 
cost of an asset not previously taken into account in basis is paid or 
incurred after the asset has been disposed of, depreciated, amortized, 
or depleted. A similar rule applies when an amount is subtracted from 
the original allocation to the asset. For purposes of the preceding 
sentence, an asset is considered to have been disposed of to the extent 
that its allocable portion of the decrease in AGUB would reduce its 
basis below zero.
    (2) Section 38 property. Section 1.47-2(c) applies to a reduction 
in basis of section 38 property under this section.
    (e) Examples. The following examples illustrate this section. Any 
amount described in the following examples is exclusive of interest. 
For rules characterizing deferred contingent payments as principal or 
interest, see 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 ($300), AGUB allocated to 
those assets is limited to those fair market values under 
Sec. 1.338-6(c)(1). As there are no Class VI assets, the remaining 
AGUB of $30 is allocated to goodwill and going concern value (Class 
VII assets). The amount of increase in AGUB allocated to each 
acquisition date asset is determined as follows:

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

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

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

    (ii) On September 30, 2004, P filed a claim against the selling 
shareholders of T in a court of appropriate jurisdiction alleging 
fraud in the sale of the T stock.
    (iii) On January 1, 2007, the former shareholders refund $140 of 
the purchase price to P in a settlement of the lawsuit.

[[Page 9947]]

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

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

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

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

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

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

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

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

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

------------------------------------------------------------------------
                                     Original   Redetermined
               Asset                  (c)(3)       (c)(3)      Increase
                                    allocation   allocation   (decrease)
------------------------------------------------------------------------
Portfolio of actively traded              $268         $266         $(2)
 securities.......................
Accounts receivable...............         536          531          (5)
Inventory.........................         268          266          (2)

[[Page 9948]]

 
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. For old 
T, this payment has no effect on ADSP, because the payment is 
accounted for as a separate transaction. We have assumed that, under 
general principles of tax law, the payment is properly taken into 
account by P at the time made. Therefore, in 2004, there is an 
increase in new T's AGUB of $120. The amount of the increase 
allocated to each acquisition date asset is determined as follows:

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

Secs. 1.338-0T through 1.338-7T  [Removed]

    Par. 4. Sections 1.338-0T through 1.338-7T are removed.

    Par. 5. 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 tax consequences are reported on the final 
return of old target filed for old target's taxable year that ends at 
the close of the acquisition date. Paragraphs (a)(2), (3) and (4) of 
this section do not apply to elections under section 338(h)(10). If old 
target is the common parent of an affiliated group, the final return 
may be a consolidated return (any such consolidated return must also 
include any deemed sale tax consequences of any members of the 
consolidated group that are acquired by the purchasing corporation on 
the same acquisition date as old target).
    (2) Old target's final taxable year otherwise included in 
consolidated return of selling group--(i) General rule. If the selling 
group files a consolidated return for the period that includes the 
acquisition date, old target is disaffiliated from that group 
immediately before the deemed asset sale and must file a deemed sale 
return separate from the group, which includes only the deemed sale tax 
consequences and the carryover items specified in paragraph (a)(2)(iii) 
of this section. The deemed asset sale occurs at the close of the 
acquisition date and is the last transaction of old target and the only 
transaction reported on the separate return. Except as provided in 
Sec. 1.338-1(d) (regarding certain transactions on the acquisition 
date), any transactions of old target occurring on the acquisition date 
other than the deemed asset sale are included in the selling group's 
consolidated return. A deemed sale return includes a combined deemed 
sale return as defined in paragraph (a)(4) of this section.
    (ii) Separate taxable year. The deemed asset sale included in the 
deemed sale return under this paragraph (a)(2) occurs in a separate 
taxable year, except that old target's taxable year of the sale and the 
consolidated year of the selling group that includes the acquisition 
date are treated as the same year for purposes of determining the

[[Page 9949]]

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 and a 
section 338 election (but not a section 338(h)(10) election) is filed 
for target, old target files a return as a C corporation reflecting its 
activities on the acquisition date, including target's deemed sale. See 
section 1362(d)(2). For purposes of this return, target is a component 
member of the controlled group of corporations including the purchasing 
corporation unless target is treated as an excluded member under 
section 1563(b)(2).
    (4) Combined deemed sale return--(i) General rule. Under section 
338(h)(15), a combined deemed sale return (combined return) may be 
filed for all targets from a single selling consolidated group (as 
defined in Sec. 1.338(h)(10)-1(b)(3)) that are acquired by the 
purchasing corporation on the same acquisition date and that otherwise 
would be required to file separate deemed sale returns. The combined 
return must include all such targets. For example, T and T1 may be 
included in a combined return if--
    (A) T and T1 are directly owned subsidiaries of S;
    (B) S is the common parent of a consolidated group; and
    (C) P makes qualified stock purchases of T and T1 on the same 
acquisition date.
    (ii) Gain and loss offsets. Gains and losses recognized on the 
deemed asset sales by targets included in a combined return are treated 
as the gains and losses of a single target. In addition, loss 
carryovers of a target that were not subject to the separate return 
limitation year restrictions (SRLY restrictions) of the consolidated 
return regulations while that target was a member of the selling 
consolidated group may be applied without limitation to the gains of 
other targets included in the combined return. If, however, a target 
has loss carryovers that were subject to the SRLY restrictions while 
that target was a member of the selling consolidated group, the use of 
those losses in the combined return continues to be subject to those 
restrictions, applied in the same manner as if the combined return were 
a consolidated return. A similar rule applies, when appropriate, to 
other tax attributes.
    (iii) Procedure for filing a combined return. A combined return is 
made by filing a single corporation income tax return in lieu of 
separate deemed sale returns for all targets required to be included in 
the combined return. The combined return reflects the deemed asset 
sales of all targets required to be included in the combined return. If 
the targets included in the combined return constitute a single 
affiliated group within the meaning of section 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 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

[[Page 9950]]

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

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

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


Sec. 1.338-10T  [Removed]

    Par. 6. Section 1.338-10T is removed.

    Par. 7. Section 1.338(h)(10)-1 is added 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. 1.338-1 through 1.338-10 and, in appropriate cases, apply instead 
of the rules of Secs. 1.338-1 through 1.338-10.
    (b) Definitions--(1) Consolidated target. A consolidated target is 
a target that is a member of a consolidated group within the meaning of 
Sec. 1.1502-1(h) on the acquisition date and is not the common parent 
of the group on that date.
    (2) Selling consolidated group. A selling consolidated group is the 
consolidated group of which the consolidated target is a member on the 
acquisition date.
    (3) Selling affiliate; affiliated target. A selling affiliate is a 
domestic corporation that owns on the acquisition date an amount of 
stock in a domestic target, which amount of stock is described in 
section 1504(a)(2), and does not join in filing a consolidated return 
with the target. In such case, the target is an affiliated target.
    (4) S corporation target. An S corporation target is a target that 
is an S corporation immediately before the acquisition date.
    (5) S corporation shareholders. S corporation shareholders are the 
S corporation target's shareholders. Unless otherwise indicated, a 
reference to S corporation shareholders refers both to S corporation 
shareholders who do and those who do not sell their target stock.
    (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

[[Page 9951]]

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 
tax consequences). For example, new T remains liable for the tax 
liabilities of the members of any consolidated group that are 
attributable to taxable years in which those corporations and old T 
joined in the same consolidated return. See Sec. 1.1502-6(a).
    (3) Old T--deemed sale--(i) In general. Old T is treated as 
transferring all of its assets to an unrelated person in exchange for 
consideration that includes the discharge of its liabilities in a 
single transaction at the close of the acquisition date (but before the 
deemed liquidation). See Sec. 1.338-1(a) regarding the tax 
characterization of the deemed asset sale. Except as provided in 
Sec. 1.338(h)(10)-1(d)(8) (regarding the installment method), old T 
recognizes all of the gain realized on the deemed transfer of its 
assets in consideration for the ADSP. ADSP for old T is determined 
under Sec. 1.338-4 and allocated among the acquisition date assets 
under Secs. 1.338-6 and 1.338-7. Old T realizes the deemed sale tax 
consequences from the deemed asset sale before the close of the 
acquisition date while old T is a member of the selling consolidated 
group (or owned by the selling affiliate or owned by the S corporation 
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 tax 
consequences are reported. When T is an S corporation target, T's S 
election continues in effect through the close of the acquisition date 
(including the time of the deemed asset sale and the deemed 
liquidation) notwithstanding section 1362(d)(2)(B). Also, when T is an 
S corporation target (but not a qualified subchapter S subsidiary), any 
direct and indirect subsidiaries of T which T has elected to treat as 
qualified subchapter S subsidiaries under section 1361(b)(3) remain 
qualified subchapter S subsidiaries through the close of the 
acquisition date.
    (ii) Tiered targets. In the case of parent-subsidiary chains of 
corporations making elections under section 338(h)(10), the deemed 
asset sale of a parent corporation is considered to precede that of its 
subsidiary. See Sec. 1.338-3(b)(4)(i).
    (4) Old T and selling consolidated group, selling affiliate, or S 
corporation shareholders--deemed liquidation; tax characterization--(i) 
In general. Old T is treated as if, before the close of the acquisition 
date, after the deemed asset sale in paragraph (d)(3) of this section, 
and while old T is a member of the selling consolidated group (or owned 
by the selling affiliate or owned by the S corporation shareholders), 
it transferred all of its assets to members of the selling consolidated 
group, the selling affiliate, or S corporation shareholders and ceased 
to exist. The transfer from old T is characterized for Federal income 
tax purposes in the same manner as if the parties had actually engaged 
in the transactions deemed to occur because of this section and taking 
into account other transactions that actually occurred or are deemed to 
occur. For example, the transfer may be treated as a distribution in 
pursuance of a plan of reorganization, a distribution in complete 
cancellation or redemption of all its stock, one of a series of 
distributions in complete cancellation or redemption of all its stock 
in accordance with a plan of liquidation, or part of a circular flow of 
cash. In most cases, the transfer will be treated as a distribution in 
complete liquidation to which section 336 or 337 applies.
    (ii) Tiered targets. In the case of parent-subsidiary chains of 
corporations making elections under section 338(h)(10), the deemed 
liquidation of a subsidiary corporation is considered to precede the 
deemed liquidation of its parent.
    (5) Selling consolidated group, selling affiliate, or S corporation 
shareholders--(i) In general. If T is an S corporation target, S 
corporation shareholders (whether or not they sell their stock) take 
their pro rata share of the deemed sale tax consequences into account 
under section 1366 and increase or decrease their basis in T stock 
under section 1367. Members of the selling consolidated group, the 
selling affiliate, or S corporation shareholders are treated as if, 
after the deemed asset sale in paragraph (d)(3) of this section and 
before the close of the acquisition date, they received the assets 
transferred by old T in the transaction described in paragraph 
(d)(4)(i) of this section. In most cases, the transfer will be treated 
as a distribution in complete liquidation to which section 331 or 332 
applies.
    (ii) Basis and holding period of T stock not acquired. A member of 
the selling consolidated group (or the selling affiliate or an S 
corporation shareholder) retaining T stock is treated as acquiring the 
stock so retained on the day after the acquisition date for its fair 
market value. The holding period for the retained stock starts on the 
day after the acquisition date. For purposes of this paragraph, the 
fair market value of all of the T stock equals the grossed-up amount 
realized on the sale to P of P's recently purchased target stock. See 
Sec. 1.338-4(c).
    (iii) T stock sale. Members of the selling consolidated group (or 
the selling affiliate or S corporation shareholders) recognize no gain 
or loss on the sale or exchange of T stock included in the qualified 
stock purchase (although they may recognize gain or loss on the T stock 
in the deemed liquidation).
    (6) Nonselling minority shareholders other than nonselling S 
corporation shareholders--(i) In general. This paragraph (d)(6) 
describes the treatment of shareholders of old T other than the 
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--

[[Page 9952]]

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

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

[[Page 9953]]

of assets. However, paragraph (d)(9) of this section states, in 
general, that no provision of section 338(h)(10) or the regulations 
thereunder shall produce a Federal income tax result under subtitle 
A of the Internal Revenue Code that would not occur if the parties 
had actually engaged in the transactions deemed to occur by virtue 
of the section 338(h)(10) election, taking into account other 
transactions that actually occurred or are deemed to occur. Hence, 
the deemed sale of assets under section 338(h)(10) should be treated 
as one of the inventory and actively traded security themselves, not 
of the inventory and Newco stock. The anti-abuse rule of Sec. 1.338-
1(c) does not apply, because the substance of the deemed sale of 
assets is a sale of the inventory and the actively traded security 
themselves, not of the inventory and the Newco stock. Otherwise, the 
anti-abuse rule might apply.
    Example 5. (i) T, a member of a selling consolidated group, has 
only one class of stock, all of which is owned by S1. On March 1 of 
Year 2, S1 sells its T stock to P for $80,000, and joins with P in 
making a section 338(h)(10) election for T. There are no selling 
costs or acquisition costs. On March 1 of Year 2, T owns land with a 
$50,000 basis and $75,000 fair market value and equipment with a 
$30,000 adjusted basis, $70,000 recomputed basis, and $60,000 fair 
market value. T also has a $40,000 liability. S1 pays old T's 
allocable share of the selling group's consolidated tax liability 
for Year 2 including the tax liability for the deemed sale tax 
consequences (a total of $13,600).
    (ii) ADSP of $120,000 ($80,000 + $40,000 + 0) is allocated to 
each asset as follows:

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

    (iii) Under paragraph (d)(3) of this section, old T has gain on 
the deemed sale of $40,000 (consisting of $16,667 of capital gain 
and $23,333 of ordinary income).
    (iv) Under paragraph (d)(5)(iii) of this section, S1 recognizes 
no gain or loss upon its sale of the old T stock to P. S1 also 
recognizes no gain or loss upon the deemed liquidation of T. See 
paragraph (d)(4) of this section and section 332.
    (v) P's basis in new T stock is P's cost for the stock, $80,000. 
See section 1012.
    (vi) Under Sec. 1.338-5, the AGUB for new T is $120,000, i.e., 
P's cost for the old T stock ($80,000) plus T's liability ($40,000). 
This AGUB is allocated as basis among the new T assets under 
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) `` .20 (the proportion of T 
stock retained by S1)).
    Example 7. (i) The facts are the same as in Example 6, except 
that K, a shareholder unrelated to T or P, owns the 20 percent of 
the T stock that is not acquired by P in the qualified stock 
purchase. K's basis in its T stock is $5,000.
    (ii) The consequences to P, T, and S1 are the same as in Example 
6.
    (iii) Under paragraph (d)(6)(iii) of this section, K recognizes 
no gain or loss, and K's basis in its T stock remains at $5,000.
    Example 8. (i) The facts are the same as in Example 5, except 
that the equipment is held by T1, a wholly-owned subsidiary of T, 
and a section 338(h)(10) election is also made for T1. The T1 stock 
has a fair market value of $60,000. T1 has no assets other than the 
equipment and no liabilities. S1 pays old T's and old T1's allocable 
shares of the selling group's consolidated tax liability for Year 2 
including the tax liability for T and T1's deemed sale tax 
consequences.
    (ii) ADSP for T is $120,000, allocated $66,667 to the land and 
$53,333 to the stock. Old T's deemed sale results in $16,667 of 
capital gain on its deemed sale of the land. Under paragraph 
(d)(5)(iii) of this section, old T does not recognize gain or loss 
on its deemed sale of the T1 stock. See section 332.
    (iii) ADSP for T1 is $53,333 (i.e., $53,333 + $0 + $0). On the 
deemed sale of the equipment, T1 recognizes ordinary income of 
$23,333.
    (iv) Under paragraph (d)(5)(iii) of this section, S1 does not 
recognize gain or loss upon its sale of the old T stock to P.
    Example 9. (i) The facts are the same as in Example 8, except 
that P already owns 20 percent of the T stock, which is nonrecently 
purchased stock with a basis of $6,000, and that P purchases the 
remaining 80 percent of the T stock from S1 for $64,000.
    (ii) The results are the same as in Example 8, except that under 
paragraph (d)(1) of this section and Sec. 1.338-5(d), P is deemed to 
have made a gain recognition election for its nonrecently purchased 
T stock. As a result, P recognizes gain of $10,000 and its basis in 
the nonrecently purchased T stock is increased from $6,000 to 
$16,000. P's basis in all the T stock is $80,000 (i.e., $64,000 + 
$16,000). The computations are as follows:
    (A) P's grossed-up basis for the recently purchased T stock is 
$64,000 (i.e., $64,000 (the basis of the recently purchased T stock) 
 x  (1-.2)/(.8) (the fraction in section 338(b)(4))).
    (B) P's basis amount for the nonrecently purchased T stock is 
$16,000 (i.e., $64,000 (the grossed-up basis in the recently 
purchased T stock)  x  (.2)/(1.0-.2) (the fraction in section 
338(b)(3)(B))).
    (C) The gain recognized on the nonrecently purchased stock is 
$10,000 (i.e., $16,000-$6,000).
    Example 10. (i) T is an S corporation whose sole class of stock 
is owned 40 percent each by A and B and 20 percent by C. T, A, B, 
and C all use the cash method of accounting. A and B each has an 
adjusted basis of $10,000 in the stock. C has an adjusted basis of 
$5,000 in the stock. A, B, and C hold no installment obligations to 
which section 453A applies. On March 1 of Year 1, A sells its stock 
to P for $40,000 in cash and B sells its stock to P for a $25,000 
note issued by P and real estate having a fair market value of 
$15,000. The $25,000 note, due in full in Year 7, is not publicly 
traded and bears adequate stated interest. A and B have no selling 
expenses. T's sole asset is real estate, which has a value of 
$110,000 and an adjusted basis of $35,000. Also, T's real estate is 
encumbered by long-outstanding purchase-money indebtedness of 
$10,000. The real estate does not have built-in gain subject to 
section 1374. A, B, and C join with P in making a section 338(h)(10) 
election for T.
    (ii) Solely for purposes of application of sections 453, 453A, 
and 453B, old T is considered in its deemed asset sale to receive 
back from new T the $25,000 note (considered issued by new T) and 
$75,000 of cash (total consideration of $80,000 paid for all the 
stock sold, which is then divided by .80 in the grossing-up, with 
the resulting figure of $100,000 then reduced by the amount of the 
installment note). Absent an election under section 453(d), gain is 
reported by old T under the installment method.
    (iii) In applying the installment method to old T's deemed asset 
sale, the contract price for old T's assets deemed sold is $100,000, 
the $110,000 selling price reduced by the indebtedness of $10,000 to 
which the assets are subject. (The $110,000 selling price is itself 
the sum of the $80,000 grossed-up in paragraph (ii) above to 
$100,000 and the $10,000 liability.) Gross profit is $75,000 
($110,000 selling price - old T's basis of $35,000). Old T's gross 
profit ratio is 0.75 (gross profit of $75,000  $100,000 
contract price). Thus, $56,250 (0.75  x  the $75,000 cash old T is 
deemed to receive in Year 1) is Year 1 gain attributable to the 
sale, and $18,750 ($75,000 - $56,250) is recovery of basis.
    (iv) In its liquidation, old T is deemed to distribute the 
$25,000 note to B, since B actually sold the stock partly for that

[[Page 9954]]

consideration. To the extent of the remaining liquidating 
distribution to B, it is deemed to receive, along with A and C, the 
balance of old T's liquidating assets in the form of cash. Under 
section 453(h), B, unless it makes an election under section 453(d), 
is not required to treat the receipt of the note as a payment for 
the T stock; P's payment of the $25,000 note in Year 7 to B is a 
payment for the T stock. Because section 453(h) applies to B, old 
T's deemed liquidating distribution of the note is, under section 
453B(h), not treated as a taxable disposition by old T.
    (v) Under section 1366, A reports 40 percent, or $22,500, of old 
T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases A's $10,000 adjusted basis in the T stock to $32,500. 
Next, in old T's deemed liquidation, A is considered to receive 
$40,000 for its old T shares, causing it to recognize an additional 
$7,500 gain in Year 1.
    (vi) Under section 1366, B reports 40 percent, or $22,500, of 
old T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases B's $10,000 adjusted basis in its T stock to $32,500. 
Next, in old T's deemed liquidation, B is considered to receive the 
$25,000 note and $15,000 of other consideration. Applying section 
453, including section 453(h), to the deemed liquidation, B's 
selling price and contract price are both $40,000. Gross profit is 
$7,500 ($40,000 selling price - B's basis of $32,500). B's gross 
profit ratio is 0.1875 (gross profit of $7,500  $40,000 
contract price). Thus, $2,812.50 (0.1875  x  $15,000) is Year 1 gain 
attributable to the deemed liquidation. In Year 7, when the $25,000 
note is paid, B has $4,687.50 (0.1875  x  $25,000) of additional 
gain.
    (vii) Under section 1366, C reports 20 percent, or $11,250, of 
old T's $56,250 gain recognized in Year 1. Under section 1367, this 
increases C's $5,000 adjusted basis in its T stock to $16,250. Next, 
in old T's deemed liquidation, C is considered to receive $20,000 
for its old T shares, causing it to recognize an additional $3,750 
gain in Year 1. Finally, under paragraph (d)(5)(ii) of this section, 
C is considered to acquire its stock in T on the day after the 
acquisition date for $20,000 (fair market value = grossed-up amount 
realized of $100,000  x  20%). C's holding period in the stock 
deemed received in new T begins at that time.

    (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.


Sec. 1.338(h)(10)-1T  [Removed]

    Par. 8. Section 1.338(h)(10)-1T is removed.
    Par. 9. Section 1.338(i)-1 is added to read as follows:


Sec. 1.338(i)-1  Effective dates.

    (a) In general. The provisions of Secs. 1.338-1 through 1.338-7, 
1.338-10 and 1.338(h)(10)-1 apply to any qualified stock purchase 
occurring after March 15, 2001. For rules applicable to qualified stock 
purchases on or before March 15, 2001, see Secs. 1.338-1T through 
1.338-7T, 1.338-10T, 1.338(h)(10)-1T and 1.338(i)-1T in effect prior to 
March 16, 2001 (see 26 CFR part 1 revised April 1, 2000).
    (b) Section 338(h)(10) elections for S corporation targets. The 
requirements of Secs. 1.338(h)(10)-1T(c)(2) and 1.338(h)(10)-1(c)(2) 
that S corporation shareholders who do not sell their stock must also 
consent to an election under section 338(h)(10) will not invalidate an 
otherwise valid election made on the September 1997 revision of Form 
8023, ``Elections Under Section 338 For Corporations Making Qualified 
Stock Purchases,'' not signed by the nonselling shareholders, provided 
that the S corporation and all of its shareholders (including 
nonselling shareholders) report the tax consequences consistently with 
the results under section 338(h)(10).


Sec. 1.338(i)-1T  [Removed]

    Par. 10. Section 1.338(i)-1T is removed.
    Par. 11. 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 March 15, 2001. For rules applicable 
to asset acquisitions on or before March 15, 2001, see Sec. 1.1060-1T 
in effect prior to March 16, 2001 (see 26 CFR part 1 revised April 1, 
2000).
    (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--
    (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

[[Page 9955]]

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 this paragraph (b)(2), 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. A purchaser is subject to 
section 1060 if--
    (i) Under general principles of tax law, the seller is not treated 
as transferring the same assets as the purchaser is treated as 
acquiring;
    (ii) The assets acquired by the purchaser constitute a trade or 
business; and
    (iii) 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.
    (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 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

[[Page 9956]]

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:

------------------------------------------------------------------------
                                                                  Fair
                             Asset                               market
                                                                  value
------------------------------------------------------------------------
By A:
  X...........................................................     $ 400
  Y...........................................................       400
  Z...........................................................       200
                                                               ---------
    Total.....................................................     1,000
                                                               =========
By B:
  D...........................................................        40
  E...........................................................        30
  F...........................................................        30
  Cash (amount)...............................................     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. 
Thus, the allocation rules of section 1060 do not apply in 
determining B's gain or loss with respect to the disposition of 
assets D, E, and F, and the allocation rules of section 1060 and 
paragraph (c) of this section are not applied to determine A's bases 
of assets D, E, and F. In addition, $900 of the $1,000 cash B gave 
to A for A's like-kind assets (X, Y, and Z) 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 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) B 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

[[Page 9957]]

 
                             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 
Commissioner, in determining the fair market values of the assets 
transferred, may disregard the parties' agreement. Assume that the 
Commissioner 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 Commissioner'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, 
``Asset Allocation Statement,'' 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 March 16, 2001, as described in paragraph (a)(2) of 
this section, see the temporary regulations under section 1060 in 
effect prior to March 16, 2001 (see 26 CFR part 1 revised April 1, 
2000).
    (B) Additional reporting requirement. When an increase or decrease 
in consideration is taken into account after the close of the 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 a partnership interest, see 
Sec. 1.755-2T(c).


Sec. 1.1060-1T  [Removed]

    Par. 12. Section 1.1060-1T is removed.

    Par. 13. Section 1.1361-1 is amended as follows:
    1. Redesignate paragraph (l)(2)(v) as paragraph (l)(2)(vi).

    2. Add a new paragraph (l)(2)(v).
    The addition reads as follows:


Sec. 1.1361-1  S corporation defined.

* * * * *
    (l) * * *
    (2) * * *
    (v) Special rule for section 338(h)(10) elections. If the 
shareholders of an S corporation sell their stock in a transaction for 
which an election is made under section 338(h)(10) and 
Sec. 1.338(h)(10)-1, the receipt of varying amounts per share by the 
shareholders will not cause the S corporation to have more than one 
class of stock, provided that the varying amounts are determined in 
arm's length negotiations with the purchaser.
* * * * *

    Par. 14. Section 1.1361-4 is amended by removing the last two 
sentences of paragraph (b)(4) and adding three sentences to read as 
follows:


Sec. 1.1361-4  Effect of QSub election.

* * * * *
    (b) * * *
    (4) Coordination with section 338 election. * * * If an S 
corporation makes an election under section 338 (without a section 
338(h)(10) election) with respect to a target, the target must file a 
final return as a C corporation reflecting the deemed sale. See 
Sec. 1.338-10(a). If the target was an S corporation on the day before 
the acquisition date, the final return as a C corporation must reflect 
the activities of the target for the acquisition date, including the 
deemed sale. See Sec. 1.338-10(a)(3).
* * * * *
    Par. 15. Section 1.1502-76 is amended by adding a parenthetical at 
the end of paragraph (b)(1)(ii)(B)(3) and before the semicolon to read 
as follows:


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

* * * * *
    (b) * * *
    (1) * * *
    (ii) * * *
    (B) * * *
    (3) * * * (but see Sec. 1.338-1(d)) * * *
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER PAPERWORK REDUCTION ACT

    Par. 16. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


    Par. 17. In Sec. 602.101, paragraph (b) is amended by removing the 
entries for Secs. 1.338-2T, 1.338-5T, 1.338-10T, 1.338(h)(10)-1T, and 
1.1060-1T from the table and adding new entries to the table in 
numerical order to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                                Current
                                                                  OMB
     CFR part or section where  identified and described        control
                                                                  No.
------------------------------------------------------------------------
                  *        *        *        *        *
1.338-2.....................................................   1545-1658
1.338-5.....................................................   1545-1658
1.338-10....................................................   1545-1658
1.338(h)(10)-1..............................................   1545-1658
                  *        *        *        *        *
1.1060-1....................................................   1545-1658
                  *        *        *        *        *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: January 4, 2001.
Jonathan Talisman,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 01-981 Filed 2-12-01; 8:45 am]
BILLING CODE 4830-01-P