[Federal Register Volume 67, Number 202 (Friday, October 18, 2002)]
[Proposed Rules]
[Pages 64331-64345]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-26449]


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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-150313-01]
RIN 1545-BA80


Redemptions Taxable as Dividends

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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

SUMMARY: This document contains proposed regulations that provide 
guidance regarding the treatment of the basis of redeemed stock when a 
distribution in redemption of such stock is treated as a dividend, as 
well as guidance regarding certain acquisitions of stock by related 
corporations that are treated as distributions in redemption of stock. 
The proposed regulations affect shareholders whose stock in a 
corporation is redeemed or is acquired by a corporation related to the 
issuer of the stock, and are necessary to provide such shareholders 
with guidance regarding the treatment of the basis of such stock. This 
document also provides notice of a public hearing on these proposed 
regulations.

DATES: Written or electronic comments must be received January 16, 
2003. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for February 20, 2003, at 10 a.m. must be 
received by January 30, 2003.

ADDRESSES: Send submissions to CC:ITA:RU (REG-150313-01), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU (REG-150313-01), 
Courier's desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC 20224. Alternatively, taxpayers may submit 
electronic comments directly to the IRS Internet site at www.irs.gov/regs. The public hearing will be held in Room 4718, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations 
generally, Lisa K. Leong, (202) 622-7530; concerning issues under 
sections 367, 861 and 864 of the Internal Revenue Code, Aaron A. 
Farmer, (202) 622-3860; concerning submissions of comments, the 
hearing, and/or to be

[[Page 64332]]

placed on the building access list to attend the hearing, Treena V. 
Garrett, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S, 
Washington, DC 20224. Comments on the collection of information should 
be received by December 17, 2002. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in these proposed regulations is in 
Sec.  1.302-5(e) and Sec.  1.1502-19(b)(5)(v). This collection of 
information is required by the IRS to verify compliance with section 
302. This information will be used to determine whether the amount of 
tax has been calculated correctly. The collection of information is 
required to properly determine the amount permitted to be taken into 
account as a loss. The respondents are shareholders (including 
individuals, corporations and pass-through entities) whose stock in a 
corporation is redeemed or is treated as redeemed.
    Estimated total annual reporting burden: 1,500 hours.
    Estimated average annual burden per respondent: 30 minutes.
    Estimated number of respondents: 3,000.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed revisions and amendments to the 
Income Tax Regulations (26 CFR part 1) under sections 302, 304, 704, 
861, 1371, 1374, and 1502 of the Internal Revenue Code (Code). The 
proposed regulations would amend the temporary and final regulations 
under sections 302, 304, 704, 861, 1371, 1374, and 1502 to provide 
guidance concerning the treatment of the basis of stock redeemed or 
treated as redeemed where the redemption proceeds are treated as a 
dividend distribution. These proposed regulations would also amend the 
final regulations under section 304 to conform them to certain of the 
amendments made to section 304 by legislation, including section 226 of 
the Tax Equity and Fiscal Responsibility Act of 1982, Public Law 97-248 
(96 Stat. 325, 490) (September 3, 1982), section 712(l) of the Deficit 
Reduction Act of 1984, Public Law 98-369 (98 Stat. 494, 953-55) (July 
18, 1984), section 1875(b) of the Tax Reform Act of 1986, Public Law 
99-514 (100 Stat. 2085, 2894) (October 22, 1986), and section 1013 of 
the Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788, 918) 
(August 5, 1997).

A. The Character of Property Received in Redemption of Stock

    Section 302 of the Code governs the tax treatment of distributions 
in redemption of stock. The rules of section 302 attempt to distinguish 
between distributions that ``may have capital-gain characteristics 
because they are not made pro rata among the various shareholders'' and 
distributions ``characterized by what happens solely at the corporate 
level by reason of the assets distributed.'' S. Rep. No. 1622, 83d 
Cong., 2d Sess. 49 (1954). Section 302(a) provides that a corporation's 
redemption of its stock is treated as a distribution in part or full 
payment in exchange for the stock if the redemption satisfies any one 
of the following criteria: (1) The redemption is not essentially 
equivalent to a dividend (section 302(b)(1)); (2) the redemption is 
substantially disproportionate (section 302(b)(2)); (3) the redemption 
completely terminates the redeemed shareholder's interest (section 
302(b)(3)); or (4) the redemption is in connection with a qualifying 
partial liquidation (section 302(b)(4)). If a redemption satisfies none 
of these criteria, pursuant to section 302(d), the redemption is 
treated as a distribution of property to which section 301 applies.
    Under sections 301(c)(1) and 316(a), a distribution is treated as a 
dividend to the extent of the redeeming corporation's earnings and 
profits. Any portion of the distribution that is not treated as a 
dividend is first applied against the adjusted basis of the redeemed 
stock to the extent of such basis under section 301(c)(2), and then 
treated as gain from the sale or exchange of property under section 
301(c)(3).

B. The Character of Property Received in Certain Stock Acquisitions

    The redemption rules of section 302 are implicated not only when an 
issuing corporation acquires its own stock, but also in the case of 
certain stock acquisitions by corporations related to the issuer of the 
acquired stock. Pursuant to section 304(a)(1), an acquisition of stock 
by a corporation from one or more persons that are in control of both 
the acquiring and issuing corporations is treated as if the property 
received in respect of the acquired stock were a distribution in 
redemption of the stock of the acquiring corporation. Prior to the 
amendments made by the Taxpayer Relief Act of 1997, section 304 
provided that, to the extent that the deemed distribution was treated 
as a distribution to which section 301 applies, the stock acquired was 
treated as having been transferred by the person from whom acquired and 
as having been received by the corporation acquiring it, as a 
contribution to the capital of such corporation. The Taxpayer Relief 
Act of 1997 amended section 304(a)(1) to provide that, to the extent 
that this deemed distribution is treated as a distribution to which 
section 301 applies, the shareholder and the acquiring corporation are 
treated as if the shareholder had transferred the stock of the issuing 
corporation to the acquiring corporation in exchange for stock of the 
acquiring corporation in a transaction to which section 351(a) applies, 
and then the acquiring corporation had redeemed the stock it was 
treated as issuing in that transaction. Pursuant to section

[[Page 64333]]

304(a)(2), an acquisition of stock by a corporation controlled by the 
issuer of the acquired stock is treated as if the property received in 
respect of the acquired stock was a distribution in redemption of the 
stock of the issuing corporation.
    For purposes of section 304, control means the ownership of stock 
possessing at least 50 percent of either the total combined voting 
power of all classes of stock entitled to vote or the total value of 
shares of all classes of stock. The determination of the amount and 
source of the distribution that is treated as a dividend is made as if 
the property received in respect of the redeemed stock were distributed 
by the acquiring corporation to the extent of its earnings and profits 
and then by the issuing corporation to the extent of its earnings and 
profits. Because section 304 recharacterizes certain stock acquisition 
transactions as redemptions of stock, transactions to which section 304 
applies implicate the redemption rules of section 302.

C. The Unutilized Basis of Stock Redeemed in Certain Transactions

    While sections 301 and 302 clearly set forth the character of 
property received in a redemption (whether actual or deemed) of stock, 
they do not prescribe the tax treatment of the unutilized basis of the 
redeemed stock or the stock treated as redeemed. In 1955, the IRS and 
Treasury promulgated regulations under section 302 that provide 
guidance in this regard in the case of an actual redemption of stock. 
Section 1.302-2(c) of the Income Tax Regulations states that ``[i]n any 
case in which an amount received in redemption of stock is treated as a 
distribution of a dividend, proper adjustment of the basis of the 
remaining stock will be made with respect to the stock redeemed.'' The 
regulation contains examples illustrating what constitutes a proper 
adjustment. In Example 1 and Example 3, the redeemed shareholder 
actually owns stock of the redeeming corporation immediately after a 
redemption that is treated as a distribution of a dividend. In those 
cases, the basis of the shares of the redeeming corporation that the 
shareholder owns after the redemption is increased by the basis of the 
redeemed shares. See also United States v. Davis, 397 U.S. 301 (1970) 
(interpreting Sec.  1.302-2(c) to shift the basis of redeemed stock to 
other shares held by the redeemed shareholder, even where those other 
shares are of a different class of stock than those redeemed); Rev. 
Rul. 66-37, 1966-1 C.B. 209 (same). In Example 2, although the redeemed 
shareholder actually owns no stock of the redeeming corporation 
immediately after a redemption that is treated as a distribution of a 
dividend, he does constructively own stock of the redeeming corporation 
immediately after the redemption by reason of his wife's continuing 
ownership of stock of the redeeming corporation. The example concludes 
that the redeemed shareholder's basis in the redeemed shares shifts to 
his wife's basis in her shares of stock of the redeeming corporation.
    In addition, on December 2, 1955, the IRS and Treasury promulgated 
Sec. Sec.  1.304-2(a) and 1.304-3(a). With respect to an acquisition of 
stock by a related corporation (other than a subsidiary), Sec.  1.304-
2(a) provides that the transferor's basis for his stock in the 
acquiring corporation is increased by the basis of the stock of the 
issuing corporation surrendered by him. Similarly, with respect to an 
acquisition of stock by a subsidiary, Sec.  1.304-3(a) provides that 
the transferor's basis in his remaining stock in the parent corporation 
is increased by the basis of the stock deemed redeemed by the parent 
corporation. The treatment of the transferor's unutilized basis in 
stock of the issuing corporation as a result of transactions subject to 
section 304(a) is the subject of Revenue Ruling 70-496 (1970-2 C.B. 
74), and Revenue Ruling 71-563 (1971-2 C.B. 175).
    In Revenue Ruling 70-496, a first-tier subsidiary (Y) of a parent 
corporation (X) sold all of its stock in a second-tier subsidiary of X 
(S) to another first-tier subsidiary of X (Z). The ruling concludes 
that the transaction is governed by sections 304(a)(1) and 302(d). 
Accordingly, the ruling holds that the sales proceeds constitute 
dividends to the extent of Z's earnings and profits and, to the extent 
in excess of such amount, constitute gain under section 301(c)(3). With 
respect to Y's basis in the sold S stock, the ruling holds that because 
Y had no direct stock ownership in Z before or after the sale, Y's 
basis in the S stock surrendered disappears and cannot be used to 
increase the basis of any asset of Y.
    In Revenue Ruling 71-563, A, an individual, owned all the stock of 
X. C, A's son, owned all of the outstanding stock of Y. A sold 25 
percent of its stock in X to Y for cash. The ruling states that, under 
section 304(a)(1), the sale is treated as a contribution by A of the 
stock of X to the capital of Y and a distribution to A by Y in 
redemption of its stock. Because the deemed redemption is governed by 
section 302(d), the cash received is taxable as a dividend to A under 
section 301(c)(1).
    Furthermore, the ruling reasons that, because A owns no stock in Y 
directly after the transaction, the basis of the X stock should be 
added to the basis of the remaining stock of X that A continues to own 
after the transaction.
    The current regulatory regime preserves, and prevents the 
elimination of, basis in transactions subject to section 302 where a 
proper adjustment may be made to the basis of the remaining stock of 
the redeeming corporation and in transactions subject to section 304 
where, immediately after the transaction, the seller owns stock of the 
acquiring corporation. In certain transactions, however, taxpayers have 
taken the position that certain adjustments are proper, even if they 
shift basis from a person that is not subject to U.S. tax to a person 
that is subject to U.S. tax or to stock other than stock of the 
redeeming corporation. Notice 2001-45 (2001-2 C.B. 129), describes a 
type of transaction with respect to which taxpayers have taken the 
position that, under Sec.  1.302-2(c), all or a portion of the basis of 
stock redeemed from a person that is not subject to U.S. tax or is 
otherwise indifferent to the Federal income tax consequences of the 
redemption of the stock is added to the basis of other stock in the 
redeeming corporation owned by a taxpayer that is subject to U.S. tax 
to create a loss on the disposition of the other stock. Although the 
IRS intends to challenge the adjustments claimed in such transactions, 
the IRS and Treasury believe it is desirable to revise the rules that 
govern accounting for unutilized basis attributable to redeemed stock 
to better reflect the purposes of the relevant Code provisions.

Explanation of Provisions

A. Rules Under Section 302

    This notice of proposed rulemaking proposes a replacement for the 
``proper adjustment'' regime of current Sec.  1.302-2(c) for taking 
into account the unutilized basis attributable to redeemed stock in any 
case in which a redemption of stock is treated as a distribution of 
property to which section 301 applies. The rules are proposed to apply 
both where the redeemed shareholder actually owns no stock of the 
redeeming corporation immediately after the redemption (a complete 
redemption) and where the redeemed shareholder actually owns stock of 
the redeeming corporation immediately after the redemption (a partial 
redemption). While consideration was given to retaining the ``proper 
adjustment'' rule of current Sec.  1.302-2(c) where only a portion of 
the

[[Page 64334]]

shareholder's interest in the redeeming corporation is redeemed, the 
IRS and Treasury believe the two situations are similar enough to 
warrant the same rules, and that the rules proposed herein best carry 
out the purposes of section 302 even where the redeemed shareholder 
continues directly to own stock in the redeeming corporation because, 
even in that case, dividend treatment under section 302 may have 
resulted from shares owned by attribution rather than directly. The 
following paragraphs describe the proposed rules.
1. General Description of the Proposed Rules
    Certain transactions that, in form, involve the redemption of 
shares are economically identical or similar to distributions to 
shareholders that do not involve any redemption of shares. For example, 
if a single shareholder owns all of the stock of the redeeming 
corporation, the redemption of some shares from that shareholder for 
cash is economically indistinguishable from the mere distribution of 
corporate cash to the shareholder. In recognition of this, section 302 
taxes these transactions as corporate distributions notwithstanding 
their form as redemptions. The underlying premise of section 302 is 
that distribution treatment is called for in these cases because, in 
effect, the redeemed shareholder still owns (or is treated as owning) 
its stock in the corporation, even if it may have turned in some 
physical shares.
    Although section 302 does not provide any explicit guidance 
regarding the shareholder's basis of the shares redeemed, in deriving a 
regulatory regime to address the treatment of the unutilized basis of 
redeemed stock, it is appropriate to consider what happens when a 
shareholder receives a distribution and keeps its shares, because that 
analogy underlies distribution treatment under section 302. Because the 
Code does not permit basis to offset any portion of the redemption 
distribution that is treated as a dividend, and because such an offset 
is not available when a corporation distributes a dividend and the 
shareholder retains its shares, the redemption date is not the 
appropriate time to recover the unutilized basis of the redeemed stock. 
However, if the shareholder receives a distribution and retains its 
shares, it also retains its basis, which it can recover later in 
situations other than dividends, such as the sale of the shares. 
Accordingly, the unutilized basis of the redeemed stock should not 
disappear and should be taken into account for Federal income tax 
purposes at some time. In addition, any tax benefit associated with the 
unutilized basis of redeemed stock should remain with the taxpayer that 
made, or succeeded to, the investment that gave rise to the unutilized 
basis. Accordingly, these regulations propose that, in any case where a 
redemption of stock is treated as a distribution of a dividend, an 
amount equal to the adjusted basis of the redeemed stock is treated as 
a loss recognized on the disposition of the redeemed stock on the date 
of the redemption. That loss is taken into account as described below.
    Once the facts and circumstances that caused the redemption 
distribution to be treated as a distribution subject to section 301 no 
longer exist (i.e., the redeemed shareholder has sufficiently reduced 
its actual and constructive ownership interest in the redeeming 
corporation), these regulations permit the loss attributable to the 
unutilized basis of redeemed stock that has not previously been taken 
into account to be taken into account. The first date on which the 
redeemed shareholder would satisfy the criteria of section 302(b)(1), 
(2) or (3) if the facts and circumstances that exist on such date had 
existed immediately after the redemption is referred to as the ``final 
inclusion date.'' In addition, a date is the final inclusion date if 
there is no later date on which the redeemed shareholder could take the 
loss into account. For example, if the redeemed shareholder is an 
individual, the final inclusion date includes the date of death of such 
individual. If the redeemed shareholder is a corporation, the final 
inclusion date includes the date such corporation transfers its assets 
in a liquidation described in section 331. If the redeemed shareholder 
is a foreign corporation, the final inclusion date includes the date 
such corporation transfers its assets to a domestic corporation in 
either a liquidation described in section 332 or a reorganization 
described in section 368(a)(1) to which section 381 applies. If the 
redeemed shareholder is a foreign corporation that is not a controlled 
foreign corporation, within the meaning of section 957(a), on the date 
of the redemption, the term final inclusion date includes the date such 
corporation transfers its assets to a controlled foreign corporation in 
a liquidation described in section 332 or a reorganization described in 
section 368(a)(1) to which section 381 applies.
    These proposed regulations also provide that the redeemed 
shareholder is permitted to take into account the loss attributable to 
the unutilized basis of redeemed stock when the redeemed shareholder 
recognizes a gain on stock of the redeeming corporation to the extent 
of the gain recognized. Any date on which the redeemed shareholder must 
take into account gain recognized pursuant to section 301(c)(3) or gain 
recognized on a disposition of stock of the redeeming corporation is 
referred to as an ``accelerated loss inclusion date.'' Although there 
can be only one final inclusion date, there can be several accelerated 
loss inclusion dates.
    Because the loss attributable to the basis of the redeemed stock is 
treated as recognized on a disposition of the redeemed stock on the 
redemption date, the attributes (e.g., character and source) of that 
loss are fixed on the redemption date, even if such loss is not taken 
into account until after the redemption date. For example, if a 
corporation redeems its stock from a shareholder within one year after 
the shareholder's acquisition of such stock and the proceeds of the 
redemption are treated as a dividend distribution, the character of any 
amount of the loss that is taken into account is treated as short-term 
capital loss (assuming the redeemed shareholder held the redeemed stock 
as a capital asset), even if such loss is taken into account more than 
one year after the redeemed shareholder's acquisition of the redeemed 
stock. Nonetheless, for purposes of the carryforward and carryback 
provisions of sections 172 and 1212, such loss is treated as a loss for 
the taxable year in which it is taken into account rather than for the 
taxable year of the stock redemption that gave rise to such loss.
    Because a redemption of stock may give rise to, or increase, an 
excess loss account in redeemed stock where the redeemed shareholder 
and the redeeming corporation are members of the same consolidated 
group, these regulations propose rules similar to those described above 
where the redeemed shareholder has an excess loss account in the 
redeemed stock.
    These proposed regulations do not apply on the redemption of stock 
described in section 306(c). Pursuant to section 306(a)(2), a 
redemption of stock described in section 306(c) is treated as a 
distribution of property to which section 301 applies. Example 2 of 
Sec.  1.306-1 suggests that the unutilized basis of redeemed section 
306 stock is added back to the basis of the stock with respect to which 
the section 306 stock was distributed. The IRS and Treasury request 
comments on whether such treatment of the unutilized basis of redeemed 
section 306 stock is appropriate or whether an alternative regime 
should apply when such a

[[Page 64335]]

redemption is treated as a distribution to which section 301 applies.
2. Special Issues Related to Certain Pass-Through Entities
    Where stock is redeemed from a partnership and all or a portion of 
the distribution in redemption of such stock is treated as a dividend, 
any loss attributable to the basis of redeemed stock is treated as a 
current loss to the partnership on the date of the redemption. To the 
extent of the lesser of the amount of such distribution that is treated 
as a dividend and such loss that is not allocated pursuant to section 
704(c) and the regulations thereunder, the dividend and the loss must 
be allocated in equal amounts. Such amounts must be allocated in 
accordance with the partners' interests in the partnership. An 
allocation will be deemed to be in accordance with a partner's interest 
in the partnership if the allocation is in the same proportion as the 
allocation of (i) the excess of the dividend income over the loss 
attributable to the basis of the redeemed stock, if any, (ii) the 
excess of the loss attributable to the basis of the redeemed stock over 
the dividend income, if any, or, (iii) if neither, in the same 
proportion as the partnership's net taxable income or loss for the year 
is allocated. This rule ensures that the benefit of the loss may be 
realized by the person to whom the dividend income was allocated. The 
excess dividend or loss attributable to the basis of redeemed stock 
must be allocated in a manner that takes into account the requirements 
of section 704.
    The loss attributable to the basis of redeemed stock allocated to a 
partner under the rules of this section is not taken into account at 
the partner level until the final inclusion date or an accelerated loss 
inclusion date, as applicable. For purposes of determining whether a 
particular date is the final inclusion date with respect to such a 
loss, if the partner is a partner of the partnership on such date, the 
partnership is treated as the redeemed shareholder. Otherwise, the 
former partner is treated as the redeemed shareholder and the 
determination of whether a particular date is the final inclusion date 
is made by comparing such former partner's actual and constructive 
ownership of the redeeming corporation immediately prior to the 
redemption to such former partner's actual and constructive ownership 
of the redeeming corporation at the end of such particular date. For 
purposes of determining whether a particular date is an accelerated 
loss inclusion date with respect to a loss attributable to the basis of 
redeemed stock that is allocated to a partner from a partnership, the 
partner is treated as the redeemed shareholder. Similar rules are 
proposed to apply where stock is redeemed from an S corporation.
    The proposed regulations provide that where stock is redeemed from 
a C corporation, and the C corporation subsequently elects to be taxed 
as an S corporation, any loss attributable to the basis of redeemed 
stock that has not been taken into account at the time of the election 
is treated as a carryforward arising in a taxable year for which the 
corporation was a C corporation. Such loss is allowed as a deduction 
against net recognized built-in gain under section 1374 in the year of 
the final inclusion date or an accelerated loss inclusion date.
    To the extent that a trust from which stock is redeemed is wholly 
or partially a grantor trust, the proposed rules treat the redeemed 
stock as having been owned directly by the grantor. When stock is 
redeemed from an estate or from a trust that is not a wholly grantor 
trust, and all or a portion of a distribution in redemption of such 
stock is treated as a dividend, any loss attributable to the basis of 
redeemed stock that is not attributable to the basis of redeemed stock 
treated as owned by the grantor is not taken into account by such 
estate or trust until the final inclusion date or an accelerated loss 
inclusion date. In that case, whether a particular date is the final 
inclusion date or an accelerated loss inclusion date is determined by 
treating such estate or trust, not its beneficiaries, as the redeemed 
shareholder. In the event that the trust or estate terminates before it 
has been permitted to take into account all of the loss attributable to 
the basis of redeemed stock, any remaining loss is treated as a loss 
under section 172 or section 1212 for purposes of section 642(h) 
(regarding the availability to beneficiaries of unused loss carryovers 
and excess deductions of an estate or trust upon termination). Each 
beneficiary's interest in the loss distributed under section 642(h), 
however, shall be limited to the proportion of that loss that is equal 
to the proportion of the total amount of the distribution treated as a 
dividend that is represented by that beneficiary's beneficial interest 
in that dividend. Once all or a portion of such a loss is distributed 
to a beneficiary, whether a particular date is the final inclusion date 
or an accelerated loss inclusion date with respect to such a loss is 
determined by treating such beneficiary as the redeemed shareholder.
3. Special Rules Related to Apportionment of Interest and Other 
Expenses
    Under section 864(e), taxpayers apportion interest expense between 
U.S. and foreign source income on the basis of the relative values of 
their U.S. and foreign assets. For this purpose, taxpayers may choose 
to value their assets using either fair market value or tax book value 
(adjusted basis). If the taxpayer apportions interest expense using tax 
book value, the adjusted basis of stock in any nonaffiliated 10 percent 
owned corporation (as defined in section 864(e)(4)(B)) is increased by 
the amount of earnings and profits (and reduced by any deficits in 
earnings and profits) attributable to such stock that accumulated 
during the period the taxpayer held such stock. The proposed 
regulations provide that for purposes of apportioning expenses on the 
basis of the tax book value of assets, the adjusted basis in any 
remaining shares of the redeeming corporation that are owned by the 
redeemed shareholder or certain affiliated corporations will be 
increased by the amount of the unutilized basis of redeemed stock. This 
adjustment is intended to provide consistent interest allocation 
consequences in the case of dividends and redemptions treated as 
dividends by nonaffiliated 10 percent owned corporations.

B. Revisions to Regulations Under Section 304

    The current regulations under section 304 do not reflect all of the 
legislative amendments that have been made to section 304. This notice 
of proposed rulemaking proposes certain revisions to the current 
regulations under section 304 to incorporate these legislative 
amendments to the extent that those legislative amendments are relevant 
to the issues that are subject to the proposed regulations under 
section 302. In particular, these revisions reflect the amendments to 
section 304 made by section 1013 of the Taxpayer Relief Act of 1997, 
Public Law 105-34 (111 Stat. 788, 918) (August 5, 1997), that provide 
that, to the extent that a stock acquisition to which section 304(a)(1) 
applies is treated as a distribution to which section 301 applies, the 
transferor and the acquiring corporation are treated as if (1) The 
transferor transferred the stock of the target corporation to the 
acquiring corporation in exchange for stock of the acquiring 
corporation in a transaction to which section 351(a) applies, and (2) 
the acquiring corporation then redeemed the stock it is treated as 
having issued. The same rules that govern an actual

[[Page 64336]]

redemption govern a deemed redemption.
    In transactions under section 304 that involve one or more foreign 
corporations, further consequences may apply under the international 
provisions of the Code. For example, where target corporation stock is 
transferred to a foreign corporation in the deemed section 351 
transaction, section 367 and the regulations promulgated thereunder 
apply to the transfer. See Rev. Rul. 91-5 (1991-1 C.B. 114) (holding 
that section 367 applied to the deemed contribution to capital of the 
target corporation stock under prior law because section 367(c)(2) 
resulted in the stock transfer constituting a section 351 transaction). 
The IRS intends to issue guidance on the application of the 
international provisions to section 304 transactions and requests 
comments on such transactions, including what changes, if any, to 
existing published guidance may be appropriate in light of the 1997 
amendments to section 304.

Proposed Effective Date

    These regulations are proposed to apply to transactions occurring 
after the date these regulations are published as final regulations in 
the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. It is hereby certified that the collection of information in 
this Notice of Proposed Rule Making will not have a significant 
economic impact on a substantial number of small entities. This 
certification is based upon the fact that the IRS and Treasury estimate 
that at most 3,000 taxpayers will be subject to these requirements and 
most of those taxpayers will be individuals or large businesses. 
Therefore, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f), this notice of proposed rulemaking will be submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for February 20, 2003, 
beginning at 10 a.m. in Room 4718 of the Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT portion of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments must submit written or electronic 
comments and an outline of the topics to be discussed and the time to 
be devoted to each topic (a signed original and eight (8) copies) by 
January 30, 2003. A period of 10 minutes will be allotted to each 
person for making comments. An agenda showing the scheduling of the 
speakers will be prepared after the deadline for receiving outlines has 
passed. Copies of the agenda will be available free of charge at the 
hearing.

Drafting Information

    The principal author of these proposed regulations is Lisa K. Leong 
of the Office of the Associate Chief Counsel (Corporate), IRS. However, 
other personnel from the IRS and Treasury participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for part 1 continues to read in part as 
follows:

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


Sec.  1.302-2  [Amended]

    2. In Sec.  1.302-2, paragraph (c) is removed.
    3. Section 1.302-5 is added to read as follows:


Sec.  1.302-5  Redemptions taxable as dividends.

    (a) In general. In any case in which an amount received in 
redemption of stock is treated as a distribution of a dividend, an 
amount equal to the basis of the redeemed stock, after adjusting such 
basis to reflect the application of section 301(c)(2), 961(b), 1059, 
Sec.  1.1502-32, or any other applicable provision of the Internal 
Revenue Code or regulations thereunder, is treated as a loss recognized 
on a disposition of the redeemed stock on the date of the redemption. 
The redeemed shareholder (as defined in paragraph (b)(1) of this 
section) shall be permitted to take such loss into account pursuant to 
the provisions of this section. Although such loss may be taken into 
account on a date later than the date of the redemption, the attributes 
(e.g., character and source) of such loss are determined on the date of 
the redemption of the stock that gave rise to such loss. See Sec.  
1.1502-19(b)(5) for rules that apply where an amount received in 
redemption of stock is treated as a dividend and such amount either 
increases or creates an excess loss account in the redeemed stock.
    (b) Definitions--(1) Redeemed shareholder. Except as provided in 
paragraphs (d)(6), (7), and (8) of this section, the redeemed 
shareholder is the person whose stock is redeemed in a transaction in 
which a portion or all of the redemption proceeds are treated as a 
dividend. If the assets of the redeemed shareholder are acquired in a 
transaction described in section 381(a), the acquiring corporation 
(within the meaning of section 381) thereafter is treated as the 
redeemed shareholder. For rules concerning the person that is treated 
as the redeemed shareholder where the redeemed stock is held by a 
partnership or an S corporation at the time of the redemption, see 
paragraphs (d)(6) and (7) of this section. For rules concerning the 
person that is treated as the redeemed shareholder where the redeemed 
stock is held by an estate or a trust not treated as wholly owned by 
the grantor or another person at the time of the redemption and a loss 
attributable to the basis of such redeemed stock is distributed to a 
beneficiary of such estate or trust, see paragraph (d)(8) of this 
section.
    (2) Redeeming corporation. Except as provided in paragraph (d)(5) 
of this section, the redeeming corporation is the corporation that 
issued the stock that is redeemed. For rules concerning the entity that 
is treated as the redeeming corporation where the redeeming corporation 
ceases to exist in a transaction described in section 381(a) or where 
the redeeming corporation distributes to its shareholders stock of one 
or more controlled corporations in a distribution described in section

[[Page 64337]]

355(a), see paragraph (d)(5) of this section.
    (3) Final inclusion date. Except as otherwise provided in 
paragraphs (d)(5), (6), (7), and (8) of this section, the final 
inclusion date is the first date on which the redeemed shareholder 
would satisfy the criteria of section 302(b)(1), (2), or (3) if the 
facts and circumstances that exist at the end of such day had existed 
immediately after the redemption. In addition, a date is the final 
inclusion date if there is no later date on which the redeemed 
shareholder could take the loss into account. For purposes of the 
preceding sentence, the existence or creation of a limitation under 
section 382 is not treated as preventing the loss from being taken into 
account. For example, if the redeemed shareholder is an individual, the 
final inclusion date includes the date of death of such individual. If 
the redeemed shareholder is a corporation, the final inclusion date 
includes the date such corporation transfers its assets in a 
liquidation described in section 331. If the redeemed shareholder is a 
foreign corporation, the final inclusion date includes the date such 
corporation transfers its assets to a domestic corporation in either a 
liquidation described in section 332 or a reorganization described in 
section 368(a)(1) to which section 381 applies. If the redeemed 
shareholder is a foreign corporation that is not a controlled foreign 
corporation, within the meaning of section 957(a), on the date of the 
redemption, the term final inclusion date includes the date such 
corporation transfers its assets to a controlled foreign corporation in 
a liquidation described in section 332 or a reorganization described in 
section 368(a)(1) to which section 381 applies.
    (4) Accelerated loss inclusion date. An accelerated loss inclusion 
date is a date other than the final inclusion date on which the 
redeemed shareholder must take into account gain from an actual or 
deemed sale or exchange of stock of the redeeming corporation. For 
example, the redeemed shareholder must take into account gain from an 
actual or deemed sale or exchange of stock of the redeeming corporation 
when such shareholder receives a distribution with respect to stock of 
the redeeming corporation to which section 301(c)(3) applies, 
recognizes gain on stock of the redeeming corporation as a result of 
the application of section 475, recognizes gain on a sale or exchange 
of stock of the redeeming corporation (even if such gain is 
characterized as a dividend under section 1248), recognizes gain in 
connection with a constructive sale of stock of the redeeming 
corporation within the meaning of section 1259, or is a partner of a 
partnership or a shareholder of an S corporation that is allocated, and 
must take into account, gain recognized on the partnership's or S 
corporation's sale or exchange of stock of the redeeming corporation.
    (c) Inclusion of loss attributable to basis of redeemed stock--(1) 
Amount taken into account on final inclusion date. On the final 
inclusion date, the redeemed shareholder is permitted to take into 
account the loss attributable to the basis of redeemed stock, reduced 
by the amount of such loss that was previously taken into account 
pursuant to paragraph (c)(2) of this section.
    (2) Amount taken into account on accelerated loss inclusion date. 
On an accelerated loss inclusion date, the redeemed shareholder is 
permitted to take into account the loss attributable to the basis of 
redeemed stock in the amount of the lesser of--
    (i) The amount of such loss reduced by the amount of such loss 
previously taken into account pursuant to this paragraph (c)(2); and
    (ii) The amount of gain recognized with respect to stock of the 
redeeming corporation that must be taken into account by the redeemed 
shareholder on such accelerated loss inclusion date.
    (d) Special rules--(1) Treatment of loss attributable to basis of 
redeemed stock. Except as otherwise provided in this section, for 
purposes of applying the provisions of the Internal Revenue Code and 
the regulations thereunder, any loss attributable to the basis of 
redeemed stock that has not been permitted to be taken into account 
shall be treated as a net operating loss carryforward or a capital loss 
carryforward, as applicable. For example, for purposes of determining 
under sections 382 and 383 whether the redeemed shareholder is a loss 
corporation that has an ownership change and whether the loss 
attributable to the basis of redeemed stock is a pre-change loss, any 
loss attributable to the basis of redeemed stock that the redeemed 
shareholder is not permitted to take into account before a testing date 
shall be treated as a net operating loss carryforward or a capital loss 
carryforward, as applicable, that arose in the taxable year in which 
the redemption that gave rise to such loss occurred and that can be 
carried forward to the taxable year that includes the testing date. If 
such loss is treated as a pre-change loss because of an ownership 
change on the testing date, it is subject to the section 382 limitation 
(and the other rules of section 382 or 383) for any post-change year in 
which it is taken into account under paragraph (c) of this section and 
any other post-change year to which it is carried pursuant to section 
172 or 1212, as applicable, and paragraph (d)(2) of this section. The 
order in which the loss is absorbed (and in which it absorbs the 
section 382 limitation (see Sec.  1.383-1(d)(2)), however, is 
determined in a manner consistent with the principles of section 172 or 
section 1212, as applicable, and paragraph (d)(2) of this section.
    (2) Net operating loss deduction and capital loss carrybacks and 
carryovers. For purposes of sections 172 and 1212, any portion of a 
loss attributable to the basis of redeemed stock shall be treated as 
occurring in the taxable year in which the redeemed shareholder is 
permitted to take such loss into account, not the taxable year of the 
redemption that gave rise to such loss. If an estate or trust 
terminates before it is permitted to take into account all of the loss 
attributable to the basis of redeemed stock, such loss that it has not 
been permitted to take into account is treated as a loss under section 
172 or 1212 for purposes of section 642(h), provided, however, that the 
identification of carryover years of the beneficiaries will be 
determined in accordance with the preceding sentence. Notwithstanding 
the preceding sentence, each beneficiary's interest in the loss 
distributed under section 642(h) shall be limited to the proportion of 
that loss that is equal to the proportion of the total amount of the 
distribution treated as a dividend that is represented by that 
beneficiary's beneficial interest in that dividend. If a deduction for 
any portion of such loss is disallowed by section 382 or 383 for the 
taxable year in which the redeemed shareholder is permitted to take 
such loss into account, such portion shall be carried forward to 
subsequent taxable years under rules similar to the rules for the 
carrying forward of net operating losses or capital losses, as 
applicable, but shall be subject to the section 382 limitation (and the 
other rules of sections 382 and 383) for any post-change year to which 
it is carried.
    (3) Expenses apportioned on the basis of assets. For special rules 
regarding adjustments in the case of taxpayers apportioning expenses on 
the basis of the tax book value of assets, see Sec.  1.861-
12(c)(2)(vi).
    (4) Effect of loss attributable to basis of redeemed stock on 
earnings and profits. If the redeemed shareholder is a corporation, any 
loss attributable to the basis of redeemed stock is not reflected in 
such corporation's earnings and profits before it is taken into account

[[Page 64338]]

pursuant to the rules of paragraph (c) of this section. See, for 
example, Sec. Sec.  1.312-6(a), 1.312-7, and 1.1502-33(c)(2).
    (5) Successors to the redeeming corporation--(i) Acquisitive 
transactions. If the assets of the redeeming corporation are acquired 
by another corporation in a transaction described in section 381(a), 
the determination of whether a particular date is the final inclusion 
date or an accelerated loss inclusion date is made by treating the 
facts and circumstances that exist at the end of such day (including 
the acquisition of the assets of the redeeming corporation) as existing 
immediately after the redemption and treating the acquiring corporation 
(within the meaning of section 381) as the redeeming corporation.
    (ii) Divisive transactions. In general, if the redeeming 
corporation distributes to its shareholders the stock of one or more 
controlled corporations in a distribution to which section 355 (or so 
much of section 356 as relates to section 355) applies, the loss 
attributable to the basis of redeemed stock is allocated among the 
stock of the distributing and any controlled corporations that the 
redeemed shareholder owns, actually and constructively pursuant to the 
rules of section 318, immediately after the distribution in proportion 
to the fair market value of the stock of the distributing corporation 
that the redeemed shareholder is treated as so owning and the 
distributed stock of the controlled corporation that the redeemed 
shareholder is treated as so owning. To the extent that such loss is 
allocated to the stock of the distributing corporation, the 
distributing corporation will be treated as the redeeming corporation 
for purposes of determining whether a particular date is the final 
inclusion date or an accelerated loss inclusion date with respect to 
such loss. To the extent that such loss is allocated to the stock of a 
controlled corporation, such controlled corporation will be treated as 
the redeeming corporation for purposes of determining whether a 
particular date is the final inclusion date or an accelerated loss 
inclusion date with respect to such loss. Where the controlled 
corporation was wholly owned by the distributing corporation and all of 
the stock of the controlled corporation was distributed to the 
shareholders of the distributing corporation in a distribution to which 
section 355 (or so much of section 356 as relates to section 355) 
applies, the determination of whether a particular date is the final 
inclusion date with respect to a loss that is allocated to a controlled 
corporation is made by treating the redeemed shareholder as owning a 
percentage of stock of the controlled corporation immediately prior to 
the redemption equal to the percentage of stock of the distributing 
corporation the redeemed shareholder actually and constructively owned 
immediately prior to the redemption. In all other cases, appropriate 
calculations shall apply to determine whether a particular date is the 
final inclusion date.
    (6) Redeemed shareholder is a partnership--(i) Treatment and 
allocation of loss attributable to basis of redeemed stock. Where stock 
is redeemed from a partnership and all or a portion of the distribution 
in redemption of such stock is treated as a dividend, any loss 
attributable to the basis of redeemed stock is treated as a current 
loss to the partnership on the date of the redemption. To the extent of 
the lesser of the amount of such distribution that is treated as a 
dividend and such loss that is not allocated pursuant to section 704(c) 
and the regulations thereunder, the dividend and the loss must be 
allocated in equal amounts. Such amounts must be allocated in 
accordance with the partners' interests in the partnership. An 
allocation will be deemed to be in accordance with a partner's interest 
in the partnership if the allocation is in the same proportion as the 
allocation of the excess of the dividend income over the loss 
attributable to the basis of the redeemed stock, if any, the excess of 
the loss attributable to the basis of the redeemed stock over the 
dividend income, if any, or, if neither, in the same proportion as the 
partnership's net taxable income or loss for the year is allocated. The 
excess dividend or loss attributable to the basis of redeemed stock 
must be allocated to the partners in a manner that takes into account 
the requirements of section 704. The loss attributable to the basis of 
redeemed stock allocated to a partner under the rules of this section 
is not taken into account until the final inclusion date or an 
accelerated loss inclusion date, as provided in this section.
    (ii) Identification of redeemed shareholder. For purposes of 
determining whether a particular date is the final inclusion date with 
respect to a loss that is allocated to a partner, if the partner is a 
partner of the partnership at the end of such day, the partnership is 
treated as the redeemed shareholder. If the partner is not a partner of 
the partnership at the end of such day, the former partner is treated 
as the redeemed shareholder and the determination of whether such date 
is the final inclusion date is made by comparing such former partner's 
actual and constructive ownership of the redeeming corporation 
immediately prior to the redemption to such former partner's actual and 
constructive ownership of the redeeming corporation at the end of such 
particular day. For purposes of determining whether a particular date 
is an accelerated loss inclusion date with respect to a loss 
attributable to the basis of redeemed stock that is allocated to a 
partner from a partnership, the partner is treated as the redeemed 
shareholder.
    (7) Redeemed shareholder is an S corporation--(i) Treatment and 
allocation of loss attributable to basis of redeemed stock. Where stock 
is redeemed from an S corporation and all or a portion of the 
distribution in redemption of such stock is treated as a dividend, any 
loss attributable to the basis of redeemed stock is treated as a 
current loss to the S corporation on the date of the redemption and is 
allocated to the S corporation's shareholders under section 1366(a). 
The portion of such loss that is allocated to an S corporation 
shareholder from the S corporation is not permitted to be taken into 
account by such shareholder until the final inclusion date or an 
accelerated loss inclusion date, as provided in this section.
    (ii) Identification of redeemed shareholder. For purposes of 
determining whether a particular date is the final inclusion date with 
respect to a loss attributable to the basis of redeemed stock that is 
allocated to a shareholder of an S corporation from an S corporation, 
if the S corporation shareholder is a shareholder of the S corporation 
at the end of such day, the S corporation is treated as the redeemed 
shareholder. If the S corporation shareholder is not a shareholder of 
the S corporation at the end of such day, the former S corporation 
shareholder is treated as the redeemed shareholder and the 
determination of whether such date is the final inclusion date is made 
by comparing such former S corporation shareholder's actual and 
constructive ownership of the redeeming corporation immediately prior 
to the redemption to such former S corporation shareholder's actual and 
constructive ownership of the redeeming corporation at the end of such 
particular day; provided, however, that for purposes of computing such 
former S corporation shareholder's ownership of the redeeming 
corporation immediately prior to the redemption, section 318(a)(2)(C) 
shall be applied without regard to the 50 percent limitation contained 
therein. For purposes of determining whether a particular date is an 
accelerated loss

[[Page 64339]]

inclusion date with respect to a loss attributable to the basis of 
redeemed stock that is allocated to an S corporation shareholder from 
an S corporation, the S corporation shareholder is treated as the 
redeemed shareholder.
    (8) Redeemed shareholder is an estate or trust. To the extent that 
a trust from which stock is redeemed is treated as owned (in part or in 
whole) by the grantor or another person under subpart E of part I of 
subchapter J of the Internal Revenue Code, the rules of this section 
are applied as though the redeemed stock were owned directly by such 
grantor or other person. Where stock is redeemed from an estate or from 
a trust not treated as wholly owned by the grantor or another person 
under subpart E of part I of subchapter J of the Internal Revenue Code, 
and all or a portion of the distribution in redemption of such stock is 
treated as a dividend, any loss attributable to the basis of redeemed 
stock, except any loss attributable to the basis of redeemed stock 
treated as owned by the grantor or another person, is not taken into 
account by such estate or trust until the final inclusion date or an 
accelerated loss inclusion date, and whether a particular date is the 
final inclusion date or an accelerated loss inclusion date is 
determined by treating such estate or trust, not its beneficiaries, as 
the redeemed shareholder. However, if all or a portion of such loss is 
distributed to a beneficiary of such estate or trust pursuant to 
section 642(h) and paragraph (d)(2) of this section, the determination 
of whether a particular date is the final inclusion date or an 
accelerated inclusion date shall be made by treating each such 
beneficiary as the redeemed shareholder with respect to the loss 
distributed to such beneficiary.
    (9) Redeemed shareholder is a C corporation that converts to an S 
corporation. For rules regarding the treatment of a loss attributable 
to the basis of redeemed stock when the redeemed shareholder is a C 
corporation on the date of the redemption and elects to be taxed as an 
S corporation prior to the final inclusion date or an accelerated loss 
inclusion date, see Sec. Sec.  1.1371-1(a)(1) and 1.1374-5(b)(2).
    (e) Statement to be filed with returns. With or as part of the 
income tax return for the year in which a redeemed shareholder takes 
into account any loss pursuant to this section, the redeemed 
shareholder shall provide a statement entitled ``Claim of Loss 
Attributable to Basis of Redeemed Stock.'' The statement shall specify 
the amount of the loss that is taken into account on such return 
pursuant to this section and shall identify the shares to which such 
amounts relate.
    (f) Examples. For purposes of the examples in this section, each of 
corporation X, corporation Y, corporation Z, corporation D, and 
corporation C is a domestic corporation that files U.S. tax returns on 
a calendar-year basis. The principles of this section are illustrated 
by the following examples:

    Example 1.  (i) Facts. A and B, husband and wife, each own 100 
shares (50 percent) of the stock of corporation X and hold the 
corporation X stock as a capital asset. A purchased his corporation 
X shares on February 1, Year 1, for $200. On December 31, Year 1, 
corporation X redeems all of A's 100 shares of its stock for $300. 
At the end of Year 1, corporation X has current and accumulated 
earnings and profits of $200. In connection with the redemption 
transaction, A does not file an agreement described in section 
302(c)(2) waiving the application of the family attribution rules. 
The redemption proceeds, therefore, are treated under section 
301(c)(1) as a dividend to the extent of corporation X's earnings 
and profits of $200, and under section 301(c)(2) as a recovery of 
basis in the amount of $100. On July 1, Year 2, B sells all of her 
shares of corporation X stock to G, her mother.
    (ii) Analysis. Under this section, an amount equal to A's basis 
in the corporation X stock ($100 after application of section 
301(c)(2)) is treated as a loss recognized on a disposition of the 
redeemed stock on December 31, Year 1, the date of the redemption. 
When B sells her shares to G, A no longer owns, actually or 
constructively, any shares of corporation X stock. Thus, if the 
facts that existed at the end of July 1, Year 2, had existed 
immediately after the redemption, A would have been treated as 
having received a distribution in part or full payment in exchange 
for the redeemed stock pursuant to section 302(a). Under this 
section, therefore, July 1, Year 2, is the final inclusion date and, 
on that date, A is permitted to take into account the loss of $100 
attributable to his basis in the redeemed stock. Because that loss 
is treated as having been recognized on a disposition of the 
redeemed stock on the date of the redemption, December 31 of Year 1, 
such loss is treated as a short-term capital loss.
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that, instead of selling all of her 100 shares of corporation 
X stock to G on July 1, Year 2, B sells only 75 shares of 
corporation X stock to G on that date.
    (ii) Analysis. As in Example 1, an amount equal to A's basis in 
the redeemed stock ($100 after application of section 301(c)(2)) is 
treated as a loss recognized on a disposition of the redeemed stock 
on December 31, Year 1, the date of the redemption. Immediately 
after B's sale of 75 shares of corporation X stock to G, A 
constructively owns 25 percent of the shares of corporation X stock. 
Thus, if the facts that existed at the end of July 1, Year 2, had 
existed immediately after the redemption, A would have been treated 
as receiving a distribution in part or full payment in exchange for 
the redeemed stock pursuant to section 302(a). Under this section, 
therefore, July 1, Year 2, is the final inclusion date and, on that 
date, A is permitted to take into account the loss of $100 
attributable to his basis in the redeemed stock. Because that loss 
is treated as having been recognized on a disposition of the 
redeemed stock on the redemption date, December 31 of Year 1, such 
loss is treated as a short-term capital loss.
    Example 3. (i) Facts. Corporation Y has 200 shares of common 
stock outstanding. L, an individual, owns 150 shares of common stock 
in corporation Y and has owned these shares for several years. The 
remaining 50 shares are owned by K, L's father. In Year 1, 
corporation Y redeems 50 shares of L's corporation Y stock, which 
have a basis of $75, for $200. At the end of Year 1, corporation Y's 
current and accumulated earnings and profits exceed $200. The 
redemption of L's stock is treated as a distribution to which 
section 301 applies. L recognizes dividend income in the amount of 
$200. In Year 4, L sells 25 of his remaining shares of corporation Y 
stock, which have a basis of $50, to K for $100 and recognizes $50 
of long-term capital gain.
    (ii) Analysis. Under this section, an amount equal to L's basis 
in the corporation Y stock that is redeemed, $75, is treated as a 
loss recognized on a disposition of the redeemed stock on the date 
of the redemption. The date on which L sells 25 shares of 
corporation Y stock to K is not the final inclusion date under 
paragraph (b)(3) of this section because L does not satisfy the 
criteria of section 302(b)(1), (2), or (3) at the end of such day. 
Under paragraph (b)(4) of this section, however, that date is an 
accelerated loss inclusion date because, on that date, L recognizes 
gain of $50 on a disposition of stock of corporation Y, the 
redeeming corporation. Thus, on that date, L is permitted to take 
into account $50 of the loss attributable to his basis in the 
redeemed stock. The remaining $25 of such loss is taken into account 
on the earlier of the final inclusion date or the next accelerated 
loss inclusion date (to the extent of gain recognized).
    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that L does not sell any shares of corporation Y to K in Year 
4. Instead, in Year 4, corporation Y distributes $75 to L with 
respect to his remaining 100 shares of corporation Y stock. L's 
basis in these shares is only $30, and at the end of Year 4, 
corporation Y's current and accumulated earnings and profits are 
$20, instead of $200. Under section 301(c)(1), $20 of the 
distribution is treated as a dividend, under section 301(c)(2), $30 
of the distribution is treated as a recovery of basis, and, under 
section 301(c)(3), $25 of the distribution is treated as gain from 
the sale or exchange of stock.
    (ii) Analysis. As in Example 3, an amount equal to L's basis in 
the corporation Y stock redeemed in Year 1, $75, is treated as a 
loss recognized on a disposition of the redeemed stock on the date 
of the redemption. Because L recognizes gain under section 301(c)(3) 
upon the receipt of the Year 4 distribution, the date of that 
distribution is an accelerated

[[Page 64340]]

loss inclusion date. Accordingly, on that date, L is permitted to 
take into account $25 of the loss attributable to the basis of the 
redeemed stock. The remaining $50 of such loss is taken into account 
on the earlier of the final inclusion date or the next accelerated 
loss inclusion date (to the extent of gain recognized).
    Example 5. (i) Facts. Corporation Z has 100 shares of stock 
outstanding, 50 shares of which are owned by each of A and his son, 
B. A's basis in each of his shares of corporation Z stock is $1. 
During Year 1, corporation Z redeems from A 25 shares of corporation 
Z stock for $200. At the end of Year 1, corporation Z has current 
and accumulated earnings and profits in excess of $200. The 
redemption is treated as a distribution to which section 301 
applies. Accordingly, A recognizes dividend income of $200. In Year 
2, corporation Y acquires all of corporation Z's assets in exchange 
solely for voting stock in a reorganization described in section 
368(a)(1)(C). In the reorganization, A and B surrender their shares 
of corporation Z stock. A receives 2,500 shares of common stock of 
corporation Y and B receives 5,000 shares of common stock of 
corporation Y. Immediately after the reorganization, corporation Y 
has outstanding one million shares of common stock.
    (ii) Analysis. Under this section, an amount equal to A's basis 
in the redeemed stock after the Year 1 redemption, $25, is treated 
as a loss recognized on a disposition of the redeemed stock on the 
date of the redemption. Under paragraph (d)(5) of this section, for 
purposes of determining whether a particular date on or after the 
date of the reorganization is the final inclusion date or an 
accelerated loss inclusion date, corporation Y, the acquiring 
corporation, is treated as the redeeming corporation. If the facts 
and circumstances that exist at the end of the day of the 
reorganization had existed on the date of the redemption, the 
redemption would have been treated as a distribution in part or full 
payment in exchange for the redeemed stock pursuant to section 
302(a). Therefore, the date of the reorganization is the final 
inclusion date and A is permitted to take into account the loss of 
$25 attributable to his basis in the redeemed stock.
    Example 6. (i) Facts. Corporation D has 300 shares of stock 
outstanding. J and her two daughters, M and N, each own 100 shares 
of corporation D stock. J's basis in her corporation D shares is 
$400. In Year 1, corporation D redeems all of J's shares for $1,000. 
At the end of Year 1, corporation D has current earnings and profits 
exceeding $1,000. The redemption is treated as a distribution to 
which section 301 applies. Accordingly, J recognizes dividend income 
in the amount of $1,000. Subsequently, M and N decide to separate 
corporation D's business. Accordingly, they cause corporation D to 
contribute one-half of its assets to corporation C, a newly formed 
corporation, in exchange for all of corporation C's stock and to 
distribute all of the corporation C stock to N in exchange for all 
of her corporation D stock. Immediately after the distribution, the 
value of corporation D is equal to the value of corporation C. In 
Year 6, M sells her shares in corporation D to an unrelated person.
    (ii) Analysis. Under this section, an amount equal to J's basis 
in the corporation D stock redeemed, $400, is treated as a loss 
recognized on a disposition of the redeemed stock on the date of the 
redemption. Upon corporation D's distribution of the stock of 
corporation C in Year 2, J's loss attributable to the basis of the 
redeemed corporation D stock is allocated among the stock of 
corporation D and corporation C that J owns, actually and 
constructively, immediately after the distribution in proportion to 
the fair market value of the stock of each such corporation. 
Although J does not actually own any stock of corporation D or 
corporation C, because J constructively owns all of the stock of 
both corporation D and corporation C and each of the stock of 
corporation D and the stock of corporation C have the same value 
immediately after the distribution, $200 of the loss is allocated to 
each of the stock of corporation D and the stock of corporation C 
that J is treated as so owning. Accordingly, each of corporation D 
and corporation C is treated as the redeeming corporation for 
purposes of determining whether a particular date after the date of 
the distribution is an accelerated loss inclusion date or the final 
inclusion date with respect to $200 of the loss. In this case, the 
date in Year 6 on which M sells her corporation D stock to an 
unrelated person is the final inclusion date with respect to J's 
loss allocated to J's constructively owned corporation D stock, 
because had corporation D's distribution of corporation C stock 
occurred immediately after the redemption of J's stock and M's Year 
6 sale of corporation D stock occurred immediately thereafter in 
Year 1, the redemption of J's corporation D stock would have been 
treated as a distribution in part or full payment in exchange for 
the redeemed stock pursuant to section 302(a). Accordingly, on that 
date in Year 6, J is permitted to take into account the $200 loss 
allocated to the corporation D stock. The $200 loss allocated to the 
corporation C stock is taken into account on the earlier of the 
final inclusion date or the next accelerated loss inclusion date (to 
the extent of gain recognized) with respect to the corporation C 
stock.
    Example 7. (i) Facts. In Year 1, A and B, two unrelated 
individuals, each contribute $100 to form a 50-50 general 
partnership, PS. A and B share in the income of PS equally. PS buys 
100 shares of corporation Z stock for $200. A owns the remaining 400 
outstanding shares of corporation Z stock directly. In Year 2, 
corporation Z redeems all of PS's shares for $300. At that time, the 
basis of A's interest in PS is $100 and the basis of B's interest in 
PS is $100. At the end of Year 2, corporation Z has current and 
accumulated earnings and profits of $150. Because A's ownership of 
the Z stock is attributed to PS under section 318(a)(3)(A), the 
redemption is treated as a distribution to which section 301 
applies. The redemption proceeds, therefore, are treated as a 
dividend to the extent of corporation Z's earnings and profits, 
$150, and as a recovery of basis in the amount of $150. Assume that 
PS's only items of income, gain, loss, deduction, and credit for 
Year 2 arise from the redemption of the corporation Z stock. On 
January 1 of Year 4, A sells his entire interest in PS to C, an 
unrelated individual.
    (ii) Analysis. Under this section, an amount equal to PS's basis 
in the corporation Z stock, ($50 after application of section 
301(c)(2)), is treated as a current loss recognized by the 
partnership on a disposition of the redeemed stock on the date of 
the redemption. Under this section, $50 of the dividend and $50 of 
the loss must be allocated in equal amounts in accordance with A's 
and B's interests in PS. Accordingly, if the remaining $100 of the 
dividend is allocated $50 to A and $50 to B under section 704 and 
the regulations thereunder, $25 of each of the dividend and the loss 
is allocated to each of A and B. A's and B's basis in their PS 
interests are increased by their shares of the dividend and 
decreased by their shares of the loss attributable to the basis of 
the redeemed stock. A and B will not be able to take that loss into 
account until the final inclusion date or an accelerated loss 
inclusion date. When A sells his PS interest to C, an unrelated 
individual, PS and A are no longer related. Therefore, PS no longer 
owns, actually or constructively, any shares of corporation Z stock. 
Because B remains a partner in PS after January 1, Year 4, PS is 
treated as the redeemed shareholder for purposes of determining if 
January 1, Year 4, is the final inclusion date for B. If the facts 
that exist at the end of the day of A's sale of his PS interest to C 
had existed immediately after the redemption, PS would have been 
treated as receiving a distribution in part or full payment in 
exchange for the redeemed stock pursuant to section 302(a). 
Therefore, B is permitted to take into account the $25 loss 
attributable to the basis of the redeemed stock that was allocated 
to him. Because A is no longer a partner in PS after January 1, Year 
4, A is treated as the redeemed shareholder for purposes of 
determining if January 1, Year 4, is the final inclusion date for A. 
Immediately prior to the redemption, A actually and constructively 
owns 90 percent of the corporation Z stock. After the sale of the PS 
interest, A actually owns 100 percent of the corporation Z stock. If 
these facts had existed immediately after the redemption, A would 
not have been treated as receiving a distribution in part or full 
payment in exchange for the redeemed stock pursuant to section 
302(a). Therefore, January 1, Year 4, is not the final inclusion 
date for A.
    Example 8. (i) Facts. H, I, and J are shareholders in 
corporation S, a corporation that has made a valid election to be 
taxed as an S corporation. H, I, and J respectively hold 60 percent, 
20 percent, and 20 percent of the stock in corporation S. H, I, and 
J have no relation to each other apart from their ownership 
interests in corporation S. Corporation S owns 20 percent of the 
outstanding shares of corporation X with a $100 adjusted basis. H 
owns the remaining outstanding shares of corporation X. In Year 1, 
all of corporation S's shares of corporation X stock are redeemed 
for their fair market value, $200. Corporation X has current and 
accumulated earnings and profits of $300 at the end of Year 1. 
Because H's ownership of

[[Page 64341]]

X stock is attributed to corporation S under section 318(a)(2)(C), 
the redemption is treated as a distribution to which section 301 
applies and is treated as a dividend. H, I, and J will be allocated 
$120, $40, and $40 of dividend income, respectively. In Year 2, J 
sells his stock of corporation S to K, an unrelated person. In Year 
3, H sells his stock of corporation X to L, an unrelated person.
    (ii) Analysis. Under this section, an amount equal to 
corporation S's basis in the redeemed stock ($100) is treated as a 
loss recognized on a disposition of the redeemed stock on the date 
of the disposition. H, I, and J will be allocated $60, $20, and $20 
of the loss, respectively, in the year of the redemption. Both the 
allocation of dividend income and the allocation of the loss give 
rise to adjustments to each shareholder's basis in corporation S. H, 
I, and J, however, will not be able to take into account this loss 
until the final inclusion date or an accelerated loss inclusion 
date. In Year 2, when J sells his stock of corporation S to K, J is 
no longer a shareholder in corporation S and will be treated as the 
redeemed shareholder for purposes of determining whether a 
particular date is the final inclusion date or an accelerated loss 
inclusion date. In addition, the determination of whether the date 
of the Year 2 sale is the final inclusion date for J is made by 
comparing J's actual and constructive ownership of corporation S 
stock immediately prior to the redemption to J's actual and 
constructive ownership of corporation S stock at the end of the date 
of the Year 2 sale. However, for purposes of computing J's ownership 
of the redeeming corporation immediately prior to the redemption, 
section 318(a)(2)(C) is applied without regard to the 50 percent 
limitation contained therein. Immediately prior to the redemption, 
therefore, J is treated as owning actually and constructively 4 
percent of the stock of corporation X and, at the end of the day of 
J's sale of corporation S stock, J owns, actually and 
constructively, no corporation X stock. Therefore, if the facts that 
existed on the date of the Year 2 sale had existed immediately after 
the redemption, J would have been treated as having received a 
distribution in part or full payment in exchange for the redeemed 
stock pursuant to section 302(a). Therefore, the date of J's sale of 
corporation S stock to K is the final inclusion date. J is permitted 
to take into account J's share of the loss attributable to the basis 
of the redeemed stock as of that date. While H and I remain 
shareholders of corporation S, whether a particular date is the 
final inclusion date will be determined by treating corporation S as 
the redeemed shareholder. Thus, in Year 3 when H disposes of his 
shares of corporation X, corporation S actually and constructively 
owns no stock of corporation X. As of that date, therefore, H and I 
will be permitted to take into account their respective shares of 
the loss attributable to the basis of the redeemed stock.
    (g) Effective date. This section applies to transactions occurring 
after the date these regulations are published as final regulations in 
the Federal Register.
    4. Section 1.304-1 is revised to read as follows:


Sec.  1.304-1  In general.

    (a) In general. Section 304 is applicable where a shareholder sells 
stock of one corporation to a related corporation as defined in section 
304. Sales to which section 304 is applicable shall be treated as 
redemptions subject to sections 302 and 303.
    (b) Effective date. This section applies to transactions occurring 
after the date these regulations are published as final regulations in 
the Federal Register.
    5. Section 1.304-2 is amended as follows:
    1. Paragraphs (a) and (c) are revised.
    2. Paragraph (d) is added.
    The revisions and addition read as follows:


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

    (a) In general. (1) If a corporation (the acquiring corporation), 
in return for property, acquires stock of another corporation (the 
issuing corporation) from one or more persons, and the person or 
persons from whom the stock was acquired were in control of both such 
corporations, then such property shall be treated as received in 
redemption of stock of the acquiring corporation. As to each person 
transferring stock, the amount received shall be treated as a 
distribution to which section 301 applies if section 302(a) or 303 does 
not apply. For rules regarding the amount constituting a dividend in 
such cases, see Sec.  1.304-6.
    (2) In applying section 302(b), reference shall be had to the 
shareholder's ownership of stock in the issuing corporation and not to 
its ownership of stock in the acquiring corporation (except for 
purposes of applying section 318(a)), section 318(a) (relating to the 
constructive ownership of stock) shall be applied without regard to the 
50 percent limitation contained in section 318(a)(2)(C) and (3)(C), and 
a series of redemptions referred to in section 302(b)(2)(D) shall 
include acquisitions by either of the corporations of stock of the 
other and stock redemptions by both corporations.
    (3) If, pursuant to section 302(d), section 301 applies to the 
property treated as received in redemption of stock of the acquiring 
corporation pursuant to paragraph (a)(1) of this section, the 
transferor and the acquiring corporation shall be treated, for all 
Federal income tax purposes, in the same manner as if the transferor 
had transferred the stock of the issuing corporation to the acquiring 
corporation in exchange for stock of the acquiring corporation in a 
transaction to which section 351(a) applies, and then the acquiring 
corporation had redeemed the stock it was treated as issuing in the 
transaction in exchange for the property. Accordingly, under section 
362, the acquiring corporation's basis in the stock of the issuing 
corporation is equal to the basis the transferor had in that stock and, 
under section 358, the transferor's basis in the stock of the acquiring 
corporation deemed issued to the transferor in the deemed transaction 
to which section 351(a) applies is equal to the transferor's basis in 
the stock of the issuing corporation it surrendered. Section 1.302-5 
applies to the transferor's unutilized basis, if any, in the stock of 
the acquiring corporation treated as redeemed in connection with an 
acquisition described in paragraph (a)(1) of this section by treating 
the acquiring corporation as the redeeming corporation and the 
transferor as the redeemed shareholder.
    (4) If section 301 does not apply to the property treated as 
received in redemption of stock of the acquiring corporation pursuant 
to paragraph (a)(1) of this section, the property received by the 
transferor shall be treated as received in a distribution in full 
payment in exchange for stock of the acquiring corporation under 
section 302(a). The basis and holding period of the stock of the 
acquiring corporation that is treated as having been redeemed shall be 
the same as the basis and holding period of the stock of the issuing 
corporation actually surrendered. The acquiring corporation shall take 
a cost basis in the stock of the issuing corporation that it acquires. 
See section 1012.
* * * * *
    (c) Examples. For purposes of the examples in this section, each of 
corporation X and corporation Y is a domestic corporation that files 
U.S. tax returns on a calendar-year basis. The principles of this 
section are illustrated by the following examples:

    Example 1. (i) Facts. Corporation X and corporation Y each have 
outstanding 100 shares of common stock. A, an individual, owns one-
half of the stock of each corporation, B owns one-half of the stock 
of corporation X, and C owns one-half of the stock of corporation Y. 
A, B, and C are unrelated. A sells 30 shares of the stock of 
corporation X, which have an adjusted basis of $10,000, to 
corporation Y for $50,000.
    (ii) Analysis. Because before the sale A owns 50 percent of the 
stock of corporation X and after the sale A owns only 35 percent of 
such stock (20 shares directly and 15 constructively because one-
half of the 30 shares owned by corporation Y are attributed to A), 
the redemption is substantially disproportionate as to A pursuant to 
the provisions of section 302(b)(2). A, therefore, realizes a gain 
of $40,000 ($50,000 minus $10,000). If the stock surrendered is a 
capital

[[Page 64342]]

asset, such gain is long-term or short-term capital gain depending 
on the period of time that such stock was held. The basis to A for 
the stock of corporation Y is not changed as a result of the sale. 
Under section 1012, the basis that corporation Y takes in the 
acquired stock of corporation X is its cost of $50,000.
    Example 2. (i) Facts. Corporation X and corporation Y each have 
outstanding 200 shares of common stock, all of which are owned by H, 
an individual. H has a basis in his corporation X stock of $60 and 
in his corporation Y stock of $30. Corporation X has $80 of current 
and accumulated earnings and profits and corporation Y has $80 of 
current and accumulated earnings and profits. H sells his 200 shares 
of corporation X stock to corporation Y for $150.
    (ii) Analysis. Because H is in control of both corporation X and 
corporation Y and receives property from corporation Y in exchange 
for the corporation X stock, H's sale of 200 shares of corporation X 
stock to corporation Y is subject to section 304(a)(1). Accordingly, 
H is treated as receiving $150 as a distribution in redemption of 
corporation Y stock. Because H actually owns 100 percent of 
corporation X before the sale and is treated as owning 100 percent 
of corporation X after the sale, pursuant to section 302(d), section 
302(a) does not apply to the deemed redemption distribution and the 
proceeds of the deemed redemption are treated as a distribution to 
which section 301 applies. Therefore, H is treated as transferring 
the corporation X stock to corporation Y in exchange for corporation 
Y stock in a transaction to which section 351(a) applies. 
Corporation Y's basis in the corporation X stock acquired is $60, 
the same basis that H had in the corporation X stock surrendered. H 
takes a basis of $60 in the corporation Y stock he is treated as 
receiving in the deemed section 351 exchange. That corporation Y 
stock is then treated as redeemed by corporation Y for $150. Under 
section 302, that redemption is treated as a distribution to which 
section 301 applies because H owns directly 100 percent of 
corporation Y both before and after the redemption of the 
corporation Y stock that was deemed issued. Thus, the deemed 
redemption proceeds are treated as a distribution to which section 
301 applies. Pursuant to Sec.  1.304-6(a), H is treated as receiving 
a dividend of $150 ($80 from the current and accumulated earnings 
and profits of corporation Y and then $70 from the current and 
accumulated earnings and profits of corporation X). An amount equal 
to the basis in the corporation Y stock that H is deemed to receive 
and that is deemed redeemed, $60 is treated as a loss recognized on 
a disposition of the stock deemed redeemed on the date of the deemed 
redemption and is taken into account under rules set forth in Sec.  
1.302-5. H's basis in the 200 shares of corporation Y stock that H 
owned before the sale and continues to own immediately after the 
sale remains $30. ?
    Example 3. (i) Facts. The facts are the same as in Example 2, 
except that corporation X has $5 of current and accumulated earnings 
and profits and corporation Y has $25 of current and accumulated 
earnings and profits.
    (ii) Analysis. As in Example 2, H takes a basis of $60 in the 
corporation Y stock he is treated as receiving and $150 is treated 
as a distribution to which section 301 applies. Pursuant to Sec.  
1.304-6(a), H is treated as receiving a dividend of $30 ($25 from 
the current and accumulated earnings and profits of corporation Y 
and $5 from the current and accumulated earnings and profits of 
corporation X). In addition, $60 of the distribution is treated as a 
return of basis and $60 of the distribution is treated as gain from 
the sale or exchange of corporation Y stock. H's basis in the 200 
shares of corporation Y stock that he owned before and continues to 
own immediately after the sale remains $30. Corporation Y's basis in 
the corporation X stock acquired is $60, the same basis that H had 
in the corporation X stock surrendered.
    Example 4. (i) Facts. A, an individual, owns 100 shares of 
corporation X stock, which is all of the outstanding stock of 
corporation X. A has a basis of $1 in each share of his corporation 
X stock. B, the son of A, owns all the outstanding stock of 
corporation Y. A sells 25 shares of the stock of corporation X to 
corporation Y for $50. For that year, the current and accumulated 
earnings and profits of corporation Y exceed $50.
    (ii) Analysis. Because A is in control of both corporation X and 
corporation Y (corporation X directly and corporation Y through 
attribution from B) and receives property in exchange for the 
corporation X stock, A's sale of corporation X stock to corporation 
Y is subject to section 304(a)(1). Consequently, A is treated as 
transferring the corporation X stock to corporation Y in exchange 
for corporation Y stock in a transaction to which section 351(a) 
applies. That corporation Y stock is then treated as redeemed by 
corporation Y for $50. Before the deemed redemption of the 
corporation Y stock, A owned 100 percent of corporation Y directly 
and constructively. After the deemed redemption, A owns 100 percent 
of corporation Y constructively by attribution from B. Accordingly, 
the redemption distribution is treated as a distribution to which 
section 301 applies. Because the earnings and profits of corporation 
Y exceed the amount of cash paid by corporation Y to A for the 
corporation X stock, pursuant to Sec.  1.304-6(a), the entire amount 
is a dividend. An amount equal to the basis in the corporation Y 
stock that A was deemed to receive and that was then deemed 
redeemed, $25, is treated as a loss recognized on a disposition of 
the stock deemed redeemed on the date of the deemed redemption and 
is taken into account under rules set forth in Sec.  1.302-5. A's 
basis in the 75 shares that he continues to hold remains $1 per 
share for an aggregate basis of $75.

    (d) Effective date. This section, except for paragraph (b) of this 
section, applies to transactions occurring after the date these 
regulations are published as final regulations in the Federal Register. 
Paragraph (b) of this section applies on and after December 2, 1955.
    6. Section 1.304-3 is amended as follows:
    1. Paragraph (a) is revised.
    2. Paragraph (c) is added.
    The revision and addition read as follows:


Sec.  1.304-3  Acquisition by a subsidiary.

    (a) In general. If a subsidiary, in return for property, acquires 
stock of its parent corporation from a shareholder of the parent 
corporation, the acquisition of such stock shall be treated as if the 
parent corporation had redeemed its own stock in exchange for the 
property. For purposes of this section, a corporation is a parent 
corporation if it meets the 50 percent ownership requirements of 
section 304(c). The determination of whether the amount received shall 
be treated as an amount received in payment in exchange for the stock 
shall be made by applying section 303, or by applying section 302(b) 
with reference to the stock of the issuing parent corporation. For 
rules regarding the amount that constitutes a dividend in a redemption 
treated as a distribution subject to section 301, see Sec.  1.304-6. 
For the treatment of the redeemed shareholder's basis in the redeemed 
stock in such cases, see Sec.  1.302-5. Section 1.302-5 applies to the 
shareholder's unutilized basis, if any, in the stock of the parent 
corporation treated as redeemed in connection with an acquisition 
described in this paragraph (a) by treating the parent corporation as 
the redeeming corporation and the shareholder as the redeemed 
shareholder.
* * * * *
    (c) Effective date. This section applies on and after December 2, 
1955, except for paragraph (a) of this section, which applies to 
transactions occurring after the date these regulations are published 
as final regulations in the Federal Register.
    7. Section 1.304-5 is amended as follows:
    1. Paragraph (a) is amended by adding a sentence at the end of the 
paragraph.
    2. Paragraph (c) is revised.
    The revision and addition read as follows:


Sec.  1.304-5  Control.

    (a) * * * Specifically, section 318(a) shall be applied by using 
the language ``5 percent'' instead of ``50 percent'' in section 
318(a)(2)(C) and by using the language ``5 percent'' instead of ``50 
percent'' in section 318(a)(3)(C), except that if section 318(a)(3)(C) 
would not have applied but for this substitution, by considering a 
corporation as owning the stock (other than stock in such corporation) 
owned by or for any shareholder of such corporation in that proportion 
which the value of the stock which such shareholder owned in such

[[Page 64343]]

corporation bears to the value of all stock in such corporation.
* * * * *
    (c) Effective date. This section applies on and after January 20, 
1994, except the last sentence of paragraph (a) of this section applies 
to transactions occurring after the date these regulations are 
published as final regulations in the Federal Register.
    8. Section 1.304-6 is added to read as follows:


Sec.  1.304-6  Amount constituting a dividend.

    (a) In general. The determination of the amount of the property 
that is a dividend is made as if the property were distributed by the 
acquiring corporation to the extent of its earnings and profits and 
then by the issuing corporation to the extent of its earnings and 
profits. Where, however, the acquiring corporation is a foreign 
corporation, for purposes of the preceding sentence, the earnings and 
profits of the acquiring corporation are taken into account only to the 
extent that they--
    (1) Are attributable to stock of the acquiring corporation owned 
(within the meaning of section 958(a)) by a corporation or individual 
that is--
    (i) A United States shareholder (within the meaning of section 
951(b)) of the acquiring corporation; and
    (ii) The transferor or a person who bears a relationship to the 
transferor described in section 267(b) or 707(b); and
    (2) Were accumulated during the period or periods such stock was 
owned by such person while the acquiring corporation was a controlled 
foreign corporation.
    (b) Effective date. This section applies to transactions occurring 
after the date these regulations are published as final regulations in 
the Federal Register.
    9. Section 1.704-1 is amended by adding paragraph (b)(4)(viii) to 
read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * *
    (4) * * *
    (viii) Loss attributable to basis of redeemed stock under Sec.  
1.302-5. For rules regarding allocations on a redemption of stock all 
or a portion of which is treated as a dividend, see Sec.  1.302-
5(d)(6)(i).
* * * * *
    10. Section 1.861-12 is added to read as follows:


Sec.  1.861-12  Characterization rules and adjustments for certain 
assets.

    (a) through (c)(2)(v) [Reserved]. For further guidance, see Sec.  
1.861-12T(a) through (c)(2)(v).
    (c)(2)(vi) Adjustments in respect of redeemed stock for taxpayers 
using the tax book value method. Solely for purposes of apportioning 
expenses on the basis of the tax book value of assets, the adjusted 
basis of any stock in a 10 percent owned corporation owned directly by 
a taxpayer that is a redeemed shareholder (as defined in Sec.  1.302-
5(b)(1)) with respect to such corporation shall be increased by the 
amount of any loss that has not been taken into account under Sec.  
1.302-5(c) as of the close of the redeemed shareholder's taxable year 
(unrecovered loss). If the redeemed shareholder does not own directly 
any shares in the 10 percent owned corporation as of the end of the 
taxable year, but is treated for purposes of section 302(b) as owning 
shares actually owned by another member of the redeemed shareholder's 
affiliated group, as defined in section 1504(a), or by a corporation 
that is either an affiliate described in Sec.  1.904(i)-1(b)(1) or an 
affiliated corporation described in Sec.  1.861-11T(d)(6) with respect 
to the redeemed shareholder, then the adjusted basis of the shares in 
the 10 percent owned corporation, if any, that are owned by such other 
corporation or corporations shall be increased by the amount of the 
redeemed shareholder's unrecovered loss (and allocated among such 
corporations, if applicable, in proportion to their relative adjusted 
bases (as adjusted pursuant to this paragraph and Sec.  1.861-
12T(c)(2)) in the stock of the redeeming corporation). These 
adjustments are to be made annually and are noncumulative.
    (vii) Examples. Certain of the rules of this paragraph (c)(2) may 
be illustrated by the following examples:

    Examples 1 and 2. [Reserved]. For further guidance, see Sec.  
1.861-12T(c)(2)((vii), Examples 1 and 2.
    Example 3. The facts are the same as in Sec.  1.861-
12T(c)(2)(vii) Example 2, except that the taxable year is 2003, and 
during the taxable year Y redeems some of the shares of its stock 
held by X for $100,000. X's adjusted basis in the redeemed shares is 
$50,000. Because X still owns all of the outstanding stock of Y, the 
redemption is treated as a distribution with respect to the stock of 
Y under section 301. Under Sec.  1.302-5, X's $50,000 adjusted basis 
in the redeemed shares is treated as a loss recognized on the date 
of the redemption, none of which is taken into account in 2003. X 
invests the $100,000 of redemption proceeds in assets that generate 
foreign source general limitation income. Under paragraph (c)(2)(vi) 
of this section, X's adjusted basis in its remaining Y stock is 
considered to be $2,000,000 ($1,950,000 adjusted basis in the Y 
stock plus $50,000 unrecovered loss in the redeemed shares). X's 
adjusted basis of assets that generate foreign source general 
limitation income is considered to be $2,500,000 ($2,000,000 
adjusted basis in the Y stock plus $500,000 other assets), and the 
resulting apportionment of interest expense is the same as in Sec.  
1.861-12T(c)(2)(vii) Example 2.

    (c)(3) through (j) [Reserved]. For further guidance, see Sec.  
1.861-12T(c)(3) through (j).
    11. Section 1.861-12T is amended as follows:
    1. Paragraph (c)(2)(vi) is redesignated as paragraph (c)(2)(vii).
    2. New paragraph (c)(2)(vi) is added.
    The addition reads as follows:


Sec.  1.861-12T  Characterization rules and adjustments for certain 
assets (temporary regulations.)

* * * * *
    (c) * * *
    (2) * * *
    (vi) [Reserved]. For further guidance, see Sec.  1.861-
12(c)(2)(vi).
* * * * *
    12. Section 1.1371-1 is added to read as follows:


Sec.  1.1371-1  Coordination with subchapter C.

    (a) No carryover between C and S years--(1) Loss attributable to 
basis of redeemed stock. A loss described in Sec.  1.302-5(a) is 
treated as a carryforward arising in a taxable year for which a 
corporation is a C corporation. Therefore, it may not be carried to a 
taxable year for which such corporation is an S corporation.
    (2) [Reserved].
    (b) Effective date. This section applies to transactions occurring 
after the date these regulations are published as final regulations in 
the Federal Register.
    13. In Sec.  1.1374-5, paragraph (a) is amended by adding a 
sentence at the end of the paragraph.


Sec.  1.1374-5  Loss carryforwards.

    (a) In general. * * * However, for redemptions of stock occurring 
after the date these regulations are published as final regulations in 
the Federal Register, a loss attributable to the basis of redeemed 
stock that is taken into account pursuant to the rules of Sec.  1.302-5 
is allowed for purposes of section 1374(b)(2) as a deduction against 
net recognized built-in gain of the S corporation for the taxable year, 
provided that the loss arose in a year in which the corporation was a C 
corporation.
* * * * *
    14. In Sec.  1.1374-10, paragraph (a) is revised to read as 
follows:


Sec.  1.1374-10  Effective date and additional rules.

    (a) In general. Except as provided in Sec.  1.1374-5(a), Sec. Sec.  
1.1374-1 through

[[Page 64344]]

1.1374-9 apply for taxable years ending on or after December 27, 1994, 
but only in cases where the S corporation's return for the taxable year 
is filed pursuant to an S election or a section 1374(d)(8) transaction 
occurring on or after December 27, 1994.
* * * * *
    15. In Sec.  1.1502-13, paragraph (f)(7) Example 3(b) is revised to 
read as follows:


Sec.  1.1502-13  Intercompany transactions.

* * * * *
    (f) * * *
    (7) * * *
    Example 3. * * *
    (b) Treatment as a section 301 distribution. The merger of S 
into B is a transaction to which paragraph (f)(3) of this section 
applies. P is treated as receiving additional B stock with a fair 
market value of $500 and, under section 358, a basis of $250. 
Immediately after the merger, $150 of the stock received is treated 
as redeemed, and the redemption is treated under section 302(d) as a 
distribution to which section 301 applies. Because the $150 
distribution is treated as not received as part of the merger, 
section 356 does not apply and no basis adjustments are required 
under section 358(a)(1)(A) and (B). Because B is treated under 
section 381(c)(2) as receiving S's earnings and profits and the 
redemption is treated as occurring after the merger, $100 of the 
distribution is treated as a dividend under section 301 and P's 
basis in the B stock is reduced correspondingly under Sec.  1.1502-
32. Under paragraph (f)(2)(ii) of this section, P's $100 of dividend 
income is not included in gross income. Accordingly, P has a $75 
excess loss account in the redeemed stock. That excess loss account 
is treated as income recognized on a disposition of the redeemed 
stock on the date of the redemption and is taken into account under 
the rules of Sec.  1.1502-19(b)(5).
* * * * *
    16. Section 1.1502-19 is amended as follows:
    1. Paragraph (b)(2)(i) is amended by adding a sentence at the end 
of the paragraph.
    2. Paragraph (b)(5) is added.
    3. Paragraph (g) Example 7 is added.
    4. The heading for paragraph (h) is revised.
    5. The first sentence of paragraph (h)(1) is removed and two new 
sentences are added in its place.
    The revisions and additions read as follows:


Sec.  1.1502-19  Excess loss accounts.

* * * * *
    (b) * * *
    (2) * * * (i) * * * As another example, if S redeems (or is treated 
as redeeming) P's S stock and, as a result, an excess loss account is 
either increased or created in such redeemed stock, P takes into 
account such excess loss account under the rules of paragraph (b)(5) of 
this section.
* * * * *
    (5) Redemptions of member stock; treatment of excess loss account 
in redeemed stock--(i) In general. In any case in which an amount 
received in redemption of S stock is treated as a distribution to P to 
which section 301 applies and such amount either increases or creates 
an excess loss account in the redeemed S stock, after adjusting such 
basis or excess loss account to reflect the application of section 
301(c)(2), section 1059, Sec.  1.1502-32, or any other applicable 
provision of the Internal Revenue Code or the regulations thereunder, 
such excess loss account is treated as income (ordinary income or gain) 
recognized on a disposition of the redeemed stock on the date of the 
redemption. Such income shall be taken into account by P under the 
provisions of this paragraph (b)(5).
    (ii) Inclusion of gain attributable to excess loss account in 
redeemed stock--(A) Amount taken into account on final inclusion date. 
On the final inclusion date (as defined in Sec.  1.302-5(b)(3)), P must 
include in income as ordinary income or gain the excess loss account in 
the redeemed stock, reduced by any amounts of such excess loss account 
that are taken into account pursuant to the provisions of paragraph 
(b)(5)(ii)(B) of this section.
    (B) Amount taken into account on accelerated income inclusion date. 
(1) On an accelerated income inclusion date (as defined in paragraph 
(b)(5)(ii)(B)(2) of this section), P must include in income as ordinary 
income or gain the excess loss account of the redeemed stock to the 
extent of the lesser of--
    (i) The amount of such excess loss account reduced by the amount of 
such excess loss account previously taken into account pursuant to this 
paragraph (b)(5)(ii); and
    (ii) The amount of loss recognized on the disposition of stock of S 
that the group of which P is a member is permitted to take into account 
on such accelerated income inclusion date without regard to the 
application of Sec.  1.337(d)-2T.
    (2) An accelerated income inclusion date is a date on which P is 
permitted to take into account a loss recognized on a disposition of S 
stock without regard to the application of Sec.  1.337(d)-2T.
    (iii) Application of other rules. In addition to the rules set 
forth in this paragraph (b)(5), the rules of Sec.  1.302-5(d) apply for 
purposes of determining the appropriate time to take into account any 
portion of an excess loss account in redeemed stock by treating P as 
the redeemed shareholder and S as the redeeming corporation. However, 
the rules of Sec.  1.302-5(d) shall be applied by using the language 
``accelerated income inclusion date'' instead of ``accelerated loss 
inclusion date'' each time that term appears.
    (iv) Statement to be filed with returns. With or as part of the 
income tax return for the year in which P takes into account any income 
attributable to an excess loss account in redeemed stock, P shall 
provide a statement entitled ``Inclusion of Income Attributable to 
Excess Loss Account in Redeemed Stock.'' The statement shall specify 
the amount of the income that is taken into account on such return 
pursuant to this paragraph (b)(5) and shall identify the shares to 
which such amounts relate.
* * * * *
    (g) * * *

    Example 7. Redemption of member stock. (a) Facts. P directly 
owns all of the outstanding stock of S1 and S2. S1 and S2 each own 
50 shares of S3's outstanding 100 shares of stock. P is the common 
parent of the consolidated group. S1's adjusted basis in the S3 
stock is $50. In Year 1, S3 redeems all of its stock from S1 for 
$100. In Year 2, P sells all of its shares of S1 stock to an 
unrelated party.
    (b) Analysis. In Year 1, because S1 actually and constructively 
owns 100 percent of stock of S3 immediately before and immediately 
after the redemption, the redemption is treated as a distribution to 
which section 301 applies. S3's distribution is an intercompany 
distribution under Sec.  1.1502-13(f)(2)(ii) and excluded from S1's 
gross income. Under Sec.  1.1502-32, S1's basis in S3's stock is 
reduced by the amount of the distribution, creating an excess loss 
account of $50. Pursuant to paragraph (b)(5)(i) of this section, 
that excess loss account is treated as income recognized on a 
disposition of the redeemed stock on the date of the redemption. 
That income, however, is not taken into account on such date. 
Instead, it is taken into account on the date on which S1 departs 
from the consolidated group as that date is the final inclusion date 
because, if the facts that exist at the end of that day had existed 
immediately after the redemption, the redemption would have been 
treated as a distribution in part or full payment in exchange for 
the redeemed stock pursuant to section 302(b)(3). Accordingly, S1 
must include in its income as gain an amount equal to the excess 
loss account in the redeemed S3 stock.

    (h) Effective dates--(1) Application. This section, except for the 
last sentence of paragraph (b)(2)(i), and paragraphs (b)(5) and (g) 
Example 7 of this section, applies with respect to determinations of 
the basis of (including an excess loss account in) the stock of a 
member in consolidated return years beginning on or after January 1, 
1995. The last

[[Page 64345]]

sentence of paragraph (b)(2)(i), and paragraphs (b)(5) and (g) Example 
7 of this section apply to transactions occurring after the date these 
regulations are published as final regulations in the Federal Register. 
* * *
* * * * *

David A. Mader,
Acting Deputy Commissioner of Internal Revenue.
[FR Doc. 02-26449 Filed 10-17-02; 8:45 am]
BILLING CODE 4830-01-P