[Federal Register Volume 71, Number 204 (Monday, October 23, 2006)]
[Proposed Rules]
[Pages 62067-62075]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-17649]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-110405-05]
RIN 1545-BE58


Limitations on Transfers of Built-in Losses

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under section 
362(e)(2) of the Internal Revenue Code of 1986 (Code). The proposed 
regulations reflect changes made to the law by the American Jobs 
Creation Act of 2004. These proposed regulations provide guidance 
regarding the determination of the bases of assets and stock 
transferred in certain nonrecognition transactions and will affect 
corporations and large shareholders of corporations, including 
individuals, partnerships, corporations, and tax-exempt entities.

DATES: Written or electronic comments and requests for a public hearing 
must be received by January 22, 2007.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-110405-05), Internal 
Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 
20044. Submissions may be hand delivered to CC:PA:LPD:PR (REG-110405-
05), Courier's Desk, Internal Revenue Service, Crystal Mall 4 Building, 
1901 S. Bell St., Arlington, VA. Alternatively, taxpayers may submit 
comments electronically directly to the IRS Internet site at 
www.irs.gov/regs or Federal e-Rulemaking Portal at www.regulations.gov 
(IRS REG-110405-05).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jay M. Singer, (202) 622-7530 (not toll-free number), or concerning 
submissions of comments, Richard A. Hurst, 
[email protected].

SUPPLEMENTARY INFORMATION: 

Background

    Prior to 1999, Congress grew concerned that taxpayers were engaging 
in corporate nonrecognition transactions in order to accelerate and 
duplicate losses. See S. Rep. No. 201, 106th Cong., 1st Sess. 46-48 
(1999). Congress was primarily concerned with the acceleration and 
duplication of losses through the assumption of liabilities (including 
liabilities to which assets transferred in a corporate nonrecognition 
transaction were subject). As a result, in 1999, Congress enacted 
section 362(d) of the Code to prevent the bases of assets transferred 
to a corporation from being increased above such assets' aggregate fair 
market value as a result of a liability assumption. In addition, in 
2000, Congress enacted section 358(h) to reduce the basis of stock 
received in certain corporate nonrecognition transactions, but not 
below fair market value, by the amount of any liabilities assumed in 
the transaction.
    Following the enactment of sections 362(d) and 358(h), Congress 
remained concerned that taxpayers were engaging in various tax-
motivated transactions to take more than one tax deduction for a single 
economic loss. Consequently, in the American Jobs Creation Act of 2004 
(Pub. L. 108-357, 188 Stat. 1418), Congress enacted section 362(e), 
which limits the ability of taxpayers to duplicate net built-in loss in 
certain nonrecognition transactions.
    Section 362(e)(1)(A) provides that if there would be an importation 
of a net built-in loss in a transaction described in section 362(a) or 
(b), the basis of certain property acquired in such a transaction shall 
be its fair market value immediately after the transaction. Section 
362(e)(1)(B) provides that property is described in section 362(e)(1) 
if gain or loss with respect to such property is not subject to tax in 
the hands of the transferor immediately before the transfer, and gain 
or loss with respect to such property is subject to tax in the hands of 
the transferee immediately after the transfer. Further, section 
362(e)(1)(C) provides that there is an importation of net built-in loss 
in a transaction if the transferee's aggregate adjusted basis in such 
property would (but for the application of section 362(e)(1)) exceed 
the aggregate fair market value of such property immediately after the 
transaction.
    Section 362(e)(2)(A) provides that if property is transferred by a 
transferor to a transferee in a transaction described in section 362(a) 
and not described in section 362(e)(1), and if the transferee's 
aggregate adjusted basis in the transferred property would (but for the 
application of section 362(e)(2)) exceed its aggregate fair market 
value immediately after the transfer, then the transferee's aggregate 
adjusted basis in the transferred property shall not exceed the fair 
market value of the property immediately after the transfer. Further, 
section 362(e)(2)(B) provides that this aggregate reduction in the 
basis of the transferred property shall be allocated among the property 
in proportion to their respective built-in losses immediately before 
the transaction. As an alternative to this reduction in the basis of 
the transferred assets, section 362(e)(2)(C) provides that if the 
transferor and the transferee both so elect, section 362(e)(2)(A) shall 
not apply, and the transferor's basis in the stock of the transferee 
received in exchange for the property that would otherwise be subject 
to basis reduction under section 362(e)(2)(A) shall not exceed its fair 
market value.
    Since the enactment of section 362(e)(2), the IRS and Treasury 
Department have been exploring issues concerning the interpretation, 
scope, and application of the section and have proposed these 
regulations to address these issues. Additional guidance regarding the 
application of section 362(e)(2) to transfers between members of a 
consolidated group and the treatment of transactions that have the 
effect of importing losses into the U.S. tax system (to which section 
362(e)(1) applies) will be addressed in separate guidance projects.

Explanation of Provisions

1. General Provisions

    In general, these proposed regulations apply to transfers of net 
built-in loss property within the U.S. tax system in

[[Page 62068]]

which the Code otherwise would duplicate the net built-in asset loss in 
the stock of the transferee. Such transfers include exchanges subject 
to section 351, capital contributions, and transfers of paid-in 
surplus. However, these proposed regulations do not apply to a transfer 
where the duplicated loss is imported into the U.S. tax system and the 
transfer is subject to section 362(e)(1), which addresses certain loss 
importation transactions. Property is net built-in loss property if the 
transferee corporation's aggregate basis in the property, but for the 
application of section 362(e)(2), would exceed the aggregate fair 
market value of such property immediately after the transfer.
    If section 362(e)(2) applies to a transfer, the transferee 
corporation receives the property with an aggregate basis not exceeding 
the aggregate fair market value of the property immediately after the 
transfer. The transferee allocates the basis reduction among the 
transferred loss properties in proportion to the amount of loss in each 
such property immediately before the transfer.
    Taxpayers have questioned the effect of any gain taken into account 
as a result of the transfer. The IRS and Treasury Department have 
determined that any gain recognized by the transferor that increases 
the transferee corporation's basis in the transferred property must be 
taken into account in order to determine the full amount of loss 
duplication. Accordingly, these proposed regulations provide that in 
determining whether the transferred property has a net built-in loss in 
the hands of the transferee, the bases of such property first must be 
increased under section 362(a) or (b) for any gain recognized by the 
transferor on the transfer of the property.
    There also have been questions about the application of section 
362(e)(2) in the case of multiple transferors. The legislative history 
to section 362(e)(2) contains some potentially conflicting language 
that refers to the aggregate adjusted basis of property contributed by 
a transferor or a control group of which the transferor is a member. 
See Conf. Rep. No. 108-755, 108th Cong., 2d Sess. 635 (2004). However, 
because the basis rules in section 362 and section 358 are applied on a 
transferor-by-transferor basis, applying section 362(e)(2) to an 
aggregated group of transferors would undermine Congress' intent to 
prevent loss duplication. Further, section 362(e)(2) specifically 
refers to property ``transferred by a transferor.'' Accordingly, these 
proposed regulations clarify that section 362(e)(2) applies separately 
to each transferor. Thus, each transferor's transfer is measured 
separately, and the determination of whether that transfer is subject 
to these provisions is made solely by reference to the property 
transferred by such transferor. Consequently, the treatment of one 
transferor is unaffected by the transfer of property by any other 
transferor for purposes of section 362(e)(2).
    In addition, these proposed regulations clarify that, even if part 
of a transaction is subject to section 362(e)(1), section 362(e)(2) can 
apply to the portion of the transaction that is not described in 
section 362(e)(1).

2. Application of Section 362(e)(2) to Transfers Outside of the U.S. 
Tax System

    Under general principles of law, the Code applies to all 
transactions without regard to whether such application has any current 
U.S. tax consequences. In the case of transfers that are wholly outside 
the U.S. tax system, section 362(e)(2) applies but does not have 
relevance unless and until the assets transferred or the stock received 
in the exchange enter the U.S. tax system. Such assets or stock may 
subsequently enter the U.S. tax system either directly or indirectly. 
For example, the assets or stock could directly enter the U.S. tax 
system through a transfer of all or a portion of such assets or stock 
to a U.S. person, or as a result of the original transferor or original 
transferee becoming a U.S. person. Further, the assets or stock could 
indirectly enter the U.S. tax system, for example, through a transfer 
of all or a portion of such assets or stock to a CFC, or as a result of 
the original transferor or original transferee becoming a CFC. However, 
in many cases the U.S. tax treatment of a transfer that is wholly 
outside the U.S. tax system will never become relevant. The IRS and 
Treasury Department recognize that, if a transferor does not anticipate 
the transfer becoming U.S. tax relevant, it is not likely to undertake 
the valuation and record-keeping that section 362(e)(2) would generally 
require. If circumstances change at some later date, the administrative 
burden of reconstructing appropriate records may be substantial.
    The IRS and Treasury Department have determined that relief is 
appropriate when transactions are consummated with no plan or intention 
to enter the U.S. tax system. Thus, if assets are transferred in a 
transaction that is potentially subject to section 362(e)(2) more than 
two years before entering the U.S. tax system, then, solely for 
purposes of section 362(e)(2), these proposed regulations generally 
presume that the aggregate fair market value of the transferred assets 
equals their aggregate adjusted basis in the hands of the transferee 
immediately after the transfer. This presumption applies only if 
neither the original transfer nor the later entry of any portion of the 
assets into the U.S. tax system was undertaken with a view to reducing 
the U.S. tax liability of any person or duplicating loss by avoiding 
the application of section 362(e)(2).
    If a transfer subject to section 362(e)(2) occurs within the two-
year period immediately before becoming U.S. tax relevant, the IRS and 
Treasury Department do not believe that relief from the administrative 
burden is either necessary or appropriate. Thus, in such a case, the 
fair market value presumption does not apply, and section 362(e)(2) 
applies to the original transfer. The proposed regulations provide the 
relevant parties a means by which to make an election under section 
362(e)(2)(C), if desired, at the time of entry into the U.S. tax 
system.

3. General Application of Section 362(e)(2) to Reorganizations

    Taxpayers have questioned whether a transaction described in both 
sections 362(a) and 362(b) may be subject to section 362(e)(2). The IRS 
and Treasury Department believe that, if there is a duplication of loss 
in a transaction described in section 362(a) (and not subject to 
section 362(e)(1)), Congressional intent requires that the transaction 
be recognized as described in section 362(a) notwithstanding that it is 
also described in section 362(b). The proposed regulations clarify that 
section 362(e)(2) can apply to such transactions.

4. Exception for Transactions in Which Net Built-in Loss Is Eliminated 
Without Recognition

    In certain transactions, the transferor's duplicated basis in the 
transferee stock or securities is eliminated by operation of statute 
without recognition or benefit. For example, in a transaction meeting 
the requirements of both sections 351 and 368(a)(1)(D), the transferor 
ordinarily receives stock with an aggregate basis equal to that of the 
transferred property. As a result, where the transferred property has a 
net-built in loss, but for section 362(e)(2), the transferor would 
receive the transferee stock with an adjusted basis that duplicates the 
built-in loss in the transferred property. However, if the transferor 
distributes the transferee stock pursuant to a section 368(a)(1)(D) 
acquisitive reorganization or pursuant to section 355, no taxpayer will 
recognize the duplicated loss because the

[[Page 62069]]

distributee will determine its basis in the transferee stock by 
reference to its basis in surrendered stock of the transferor.
    The IRS and Treasury Department have concluded that, even if a 
transaction is described in section 362(e)(2), if there is no 
duplicated loss that can be recognized, section 362(e)(2) should not 
apply. Accordingly, these proposed regulations provide that section 
362(e)(2) will not apply to transactions to the extent that loss 
duplication is prevented or eliminated where the transferor distributes 
the transferee stock and/or securities received in the transaction 
without recognizing gain or loss, and, upon completion of the 
transaction, no person holds any asset with a basis determined in whole 
or in part by reference to the transferor's basis in the transferee 
stock and/or securities.

5. Application of Section 362(e)(2) to Transfers in Exchange for 
Securities

    In certain transactions, net built-in loss also can be duplicated 
in securities received without the recognition of gain or loss. For 
example, a U.S. transferor duplicates a net built-in loss when it 
transfers property with a net built-in loss to a U.S. controlled 
corporation in exchange for stock and securities and all or part of the 
securities are retained following the distribution of the stock of the 
controlled corporation pursuant to section 355. Such a transaction is 
described in section 362(a) but not section 362(e)(1) and, accordingly, 
may be subject to section 362(e)(2).
    Although the statute is silent about the treatment of securities 
received in such a property transfer, the IRS and Treasury Department 
have concluded that Congressional intent would be circumvented if 
section 362(e)(2) were treated as not applying to both stock and 
securities received in transactions to which section 362(e)(2) applies. 
Accordingly, these proposed regulations apply section 362(e)(2) to 
transfers in exchange for both stock and securities to the extent 
necessary to eliminate loss duplication.
    Because the section applies equally to transfers in exchange for 
both stock and securities, the IRS and Treasury Department have 
concluded that taxpayers must be allowed to make an election under 
section 362(e)(2)(C) for both stock and securities. Accordingly, these 
proposed regulations allow the transferor and transferee to elect to 
apply section 362(e)(2)(C) to the transferee stock and securities 
received in the exchange.

6. Election To Reduce Stock Basis

    Section 362(e)(2)(C) permits transferors and transferees that 
engage in transactions to which section 362(e)(2) applies to elect to 
reduce the transferor's basis in the stock received instead of reducing 
the transferee corporation's basis in the property transferred. As 
described in this preamble, section 362(e)(2)(C) provides that if the 
election is made, section 362(e)(2)(A) shall not apply, and the 
transferor's basis in the transferee stock received in the exchange 
shall not exceed its fair market value immediately after the exchange. 
The statutory language might be interpreted to require the transferor 
to reduce its basis in the stock received by an amount that is larger 
than the amount by which the transferee otherwise would have been 
required to reduce its aggregate basis in the assets under section 
362(e)(2)(A). For example, assume a corporation, P, contributes a trade 
or business to a subsidiary, S, in a transaction to which section 351 
applies. The assets of the business have an aggregate adjusted basis of 
$100 and a value of $90, and the business has $20 of associated 
contingent liabilities. Even if section 358(h)(2)(A) applies to prevent 
section 358 from reducing P's basis in the S stock by the amount of the 
contingent liabilities, section 362(e)(2)(C) might be interpreted to 
limit P's basis in the S stock to $70 (notwithstanding that section 
362(e)(2)(A) would only require a $10 reduction in the basis of the 
assets in the hands of S). Thus, a section 362(e)(2)(C) election might 
result in a larger basis reduction in the stock than would be required 
in the assets absent an election.
    The IRS and Treasury Department believe that, because section 
362(e)(2) is intended to prevent the duplication of net built-in loss 
in the transferred assets, the amount of basis reduction resulting from 
an election under section 362(e)(2)(C) should not be any larger than 
what is necessary to eliminate the duplication of loss in the 
transferred assets. Therefore, these proposed regulations clarify that 
the amount of the reduction in the basis of the transferee stock (and 
securities) as a result of an election to apply section 362(e)(2)(C) is 
equal to the net built-in loss in the transferred assets in the hands 
of the transferee. In other words, under the proposed regulations, the 
amount of the reduction in the basis of the transferee stock (and 
securities) resulting from such an election equals the amount of the 
reduction in the basis of the assets required by section 362(e)(2)(A) 
absent the election.
    These proposed regulations also implement Notice 2005-70, 2005-41 
IRB 694, see Sec.  601.601(d)(2), which instructs taxpayers how to 
elect to apply section 362(e)(2)(C). These proposed regulations revise 
and expand upon the procedures in Notice 2005-70 to provide more 
methods and time periods in which to make the section 362(e)(2)(C) 
election. Specifically, the regulations expand the classifications of 
persons who can attach the required election statement to a tax return 
(including an information return).
    The ``protective election'' referenced in Notice 2005-70 also is 
included in the proposed regulations because the IRS and Treasury 
Department anticipate that, at the time of the transaction, taxpayers 
may not always be able to determine with reasonable certainty whether 
section 362(e)(2) applies to a transfer.
    The IRS and Treasury Department request comments on whether the 
instructions provided in these proposed regulations adequately address 
the needs of taxpayers. In particular, the IRS and Treasury Department 
invite comments regarding whether, alternatively, a separate form 
should be developed and made available to enable taxpayers to make the 
section 362(e)(2)(C) election prior to and apart from filing it with a 
U.S. return.
    The basis tracing provisions in Sec.  1.358-2 apply to certain 
transfers to which section 351 and either section 354 or section 356 
apply. However, the IRS and Treasury Department believe that the basis 
tracing provisions in Sec.  1.358-2 should not apply to a transfer to 
which section 362(e)(2) also applies if the transferor and transferee 
make an election to apply section 362(e)(2)(C). The IRS and Treasury 
Department believe that the statutory language in section 362(e)(2)(C) 
and the policy of preventing loss duplication precludes the application 
of the basis tracing provisions because basis tracing could allow the 
transferor to hold transferee stock or securities with a basis in 
excess of fair market value even after a reduction under section 
362(e)(2)(C). Accordingly, these proposed regulations provide that the 
provisions of Sec.  1.358-2(a)(2) will not apply to a transaction to 
which section 362(e)(2) applies if the transferor and transferee elect 
to apply section 362(e)(2)(C). The IRS and Treasury Department request 
comments regarding whether this treatment is appropriate.

7. Transfers by Partnerships and S Corporations

    The proposed regulations also provide that, where the transferor is 
a

[[Page 62070]]

partnership and a section 362(e)(2)(C) election is made, any reduction 
to the partnership's basis in the transferee stock received is treated 
as an expenditure of the partnership, as described in section 
705(a)(2)(B). The proposed regulations provide a similar rule 
applicable to transfers by S corporations that elect to apply section 
362(e)(2)(C).
    The IRS and Treasury Department are further exploring how the 
provisions of section 362(e)(2) apply to partnerships. The IRS and 
Treasury Department invite comments on this general issue and 
specifically invite comments regarding the transfer of a partnership 
interest in exchange for stock in a section 351 transaction to which 
section 362(e)(2) applies. For example, individuals A and B contribute 
cash to form a partnership, PRS. PRS purchases property that 
subsequently decreases in value. A contributes his PRS interest to a 
corporation in a transaction that qualifies under section 351. PRS does 
not make an election under section 754. Comments are invited regarding 
the interaction of section 362(e)(2) and the partnership provisions 
under these and similar facts.

8. Application of Section 336(d) to Property Previously Transferred in 
a Section 362(e)(2) Transaction

    Commentators have questioned how section 362(e)(2) interacts with 
other Code sections. Specifically, some have asked how section 
362(e)(2) applies when section 336(d) might be implicated. Section 
336(d) provides various limitations on a liquidating corporation's 
ability to recognize loss when it distributes property acquired in a 
section 351 transaction or as a contribution to capital. The IRS and 
Treasury Department believe that, generally, sections 336(d) and 
362(e)(2) are fully compatible where the parties do not make an 
election to apply section 362(e)(2)(C). However, where an election has 
been made, the two sections may operate to deny part or all of an 
economic loss. The IRS and Treasury Department invite comments 
regarding this issue.

9. Application to Section 304 Transactions

    In response to inquiries, the proposed regulations contain an 
example demonstrating how section 362(e)(2) applies to a section 351 
transaction treated as occurring under section 304. The IRS and 
Treasury Department are considering whether the regulations should deem 
an election to apply section 362(e)(2)(C) to have been made in section 
304 transactions. The IRS and Treasury Department invite comments 
regarding this issue.

Proposed Effective Date

    These proposed 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. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and, because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this regulation has 
been submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Requests for a 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 may be scheduled if requested in writing by any person who 
timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place of the hearing will be published in 
the Federal Register.

Drafting Information

    The principal authors of these regulations are Jay M. Singer and 
Filiz A. Serbes of the Office of Associate Chief Counsel (Corporate), 
IRS. However, other personnel from the IRS and Treasury Department 
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

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

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

    Section 1.362-4 also issued under 26 U.S.C. 362. * * *
    Par. 2. Section 1.358-2 is amended by revising paragraphs 
(a)(2)(viii) and adding a new sentence at the end of paragraph (d) to 
read as follows:


Sec.  1.358-2  Allocation of basis among nonrecognition property.

    (a) * * *
    (2) * * *
    (viii) This paragraph (a)(2) shall not apply to determine the basis 
of a share of stock or security received by a shareholder or security 
holder in an exchange described in both section 351 and either section 
354 or section 356, if, in connection with the exchange, the 
shareholder or security holder exchanges property for stock or 
securities in an exchange to which neither section 354 nor section 356 
applies, the shareholder or security holder exchanges property for 
stock or securities to which it elects to apply section 362(e)(2)(C), 
or liabilities of the shareholder or security holder are assumed.
* * * * *
    (d) * * * Paragraph (a)(2)(viii) of this section applies to 
exchanges and distributions of stock occurring after the date these 
regulations are published as final regulations in the Federal Register.
    Par. 3. In Sec.  1.362-3, the section heading is added and reserved 
to read as follows:


Sec.  1.362-3  Limitations on loss importation. [Reserved].

    Par. 4. Section 1.362-4 is added to read as follows:


Sec.  1.362-4  Limitations on built-in loss duplication.

    (a) Purpose and scope. The purpose of this section is to prevent 
the duplication of net built-in loss in transactions described in 
section 362(e)(2). Section 362(e)(2) applies to transfers of net built-
in loss property described in section 362(a) but only to the extent not 
described in section 362(e)(1).
    (b) Application--(1) In general. If property is transferred in any 
transaction described in section 362(a) but not section 362(e)(1), and, 
in the hands of the transferee, the transferred property would 
otherwise have a net built-in loss immediately after the transfer, then 
the transferee corporation receives such property with an aggregate

[[Page 62071]]

adjusted basis not exceeding the aggregate fair market value of such 
property immediately after the transfer. If multiple built-in loss 
properties are transferred, the aggregate reduction in basis shall be 
allocated among the built-in loss properties so transferred in 
proportion to the relative amount of built-in loss in each property.
    (2) Multiple transferors. If more than one transferor transfers 
property to a corporation in a transaction described in section 362(a), 
whether and the extent to which this section applies is determined 
separately for each transferor.
    (3) Transactions described in section 362(e)(1). A transfer of 
property to a corporation is described in section 362(e)(1) only if and 
to the extent that the transferred property described in section 
362(e)(1)(B) (section 362(e)(1)(B) property) would otherwise have a net 
built-in loss in the hands of the transferee. Thus, if a transferor 
transfers net built-in loss section 362(e)(1)(B) property together with 
property not described in section 362(e)(1)(B), the transfer of the net 
built-in loss section 362(e)(1)(B) property is described in section 
362(e)(1). Accordingly, the net built-in loss section 362(e)(1)(B) 
property is not taken into account for purposes of determining whether 
section 362(e)(2) applies to the transfer of the other property. 
Alternatively, if a transferor transfers net built-in gain section 
362(e)(1)(B) property together with property not described in section 
362(e)(1)(B), no portion of the transfer is described in section 
362(e)(1).
    (4) Net built-in loss--(i) In general. Transferred property has a 
net built-in loss if its aggregate adjusted basis exceeds its aggregate 
fair market value.
    (ii) Basis adjustments for gain recognized on the transfer. For 
purposes of determining whether the transferred property has a net 
built-in loss in the hands of the transferee, the bases of such 
property first must be increased under section 362(a) or (b) for any 
gain recognized by the transferor on the transfer of such property.
    (5) Application of section 362(e)(2) to reorganizations. Section 
362(e)(2) can apply to a transfer regardless of whether the basis of 
the property would, but for section 362(e)(2), be determined under 
section 362(b).
    (6) Exception for transactions in which net built-in loss is 
eliminated without recognition. Section 362(e)(2) does not apply to a 
transfer of property to the extent that--
    (i) The transferor distributes, without recognizing gain or loss, 
all of the transferee stock received in exchange for the transferred 
property; and
    (ii) Upon completion of the transaction, no person holds transferee 
stock or any other asset with a basis determined in whole or in part by 
reference to the transferor's basis in the transferee stock.
    (7) Transfers where neither party is a U.S. person, a person 
otherwise required to file a U.S. return, or a CFC. If property is 
transferred in a transaction described in section 362(a) but not 
section 362(e)(1), then, solely for purposes of section 362(e)(2), the 
aggregate fair market value of the transferred property shall be deemed 
to equal the aggregate adjusted basis of such property in the hands of 
the transferee immediately after the transfer if--
    (i) Neither party to the transfer was a United States (U.S.) person 
(as defined in section 7701(a)(30)) on the date of the transfer;
    (ii) Neither party to the transfer was required to file a return of 
tax under Subtitle A of the Internal Revenue Code (including an 
information return) for the year of the transfer;
    (iii) Neither party to the transfer was a controlled foreign 
corporation (CFC), as defined in section 957, on the date of the 
transfer;
    (iv) The transfer occurred more than two years prior to the date on 
which the transferor, transferee, or transferred assets are first 
described in paragraph (c)(5)(iii) of this section; and
    (v) Neither the transfer nor the later entry into the U.S. tax 
system was entered into with a view to reducing the U.S. Federal income 
tax liability of any person or duplicating loss by avoiding the 
application of section 362(e)(2).
    (c) Section 362(e)(2)(C) election to apply limitation to 
transferor's stock basis--(1) In general. If section 362(e)(2) applies 
to a transfer, the transferor and the transferee may make a joint 
election to reduce the transferor's basis in the transferee stock 
instead of reducing the transferee's basis in the property received 
under paragraph (b) of this section. Once made, the election is 
irrevocable. If the election is made, the transferor's basis in the 
transferee stock is reduced upon receipt by the transferor. The 
transferor and the transferee may make a protective election under this 
section, which will have no effect if section 362(e)(2) does not apply 
to the transfer, but which will otherwise be binding and irrevocable.
    (2) Stock and securities to which this section applies. For 
purposes of this section, the term stock means stock and securities 
received without the recognition of gain or loss in a transaction to 
which section 362(e)(2) applies. See, for example, transactions 
described in sections 368(a)(1)(D) and 355.
    (3) Amount of basis reduction. If an election is made pursuant to 
paragraph (c)(1) of this section, the amount of the basis reduction in 
the transferee stock received by the transferor in the transaction is 
equal to the total amount by which the aggregate basis of the 
transferred property would have been reduced under paragraph (b) of 
this section had such election not been made.
    (4) Allocation of basis reduction. The transferor shall allocate 
the amount of the basis reduction under this paragraph (c) among all 
transferee stock received in the transaction in proportion to fair 
market value.
    (5) Procedures for making the election--(i) In general. To make an 
election to apply section 362(e)(2)(C)--
    (A) Prior to filing the election statement as described in 
paragraph (c)(5)(ii) or (c)(5)(iii) of this section, the transferor and 
transferee must execute a written, binding agreement electing to apply 
section 362(e)(2)(C); and
    (B) An election statement must be filed pursuant to paragraph 
(c)(5)(ii) or (c)(5)(iii) of this section.
    (ii) Election statement where the transferor or transferee is a 
U.S. person, a person otherwise required to file a U.S. return for the 
year of the transfer, or a CFC on the date of the transfer--(A) 
Transferor is a U.S. person or a person otherwise required to file a 
U.S. return for the year of the transfer. If the transferor is a U.S. 
person on the date of the transfer or a person otherwise required to 
make a return of tax under Subtitle A of the Internal Revenue Code 
(including an information return) for the year of the transfer, the 
election statement is filed by including the following statement on or 
with the transferor's timely filed original return (including 
extensions) for the taxable year in which the transfer occurred: 
``[insert name and tax identification number of transferor] certifies 
that [insert name and tax identification number of transferor] and 
[insert name and tax identification number, if any, of transferee] 
elect to apply section 362(e)(2)(C) with respect to a transfer of 
property described in section 362(e)(2)(A) on [insert date(s) of 
transfer(s)].''
    (B) Transferor is a CFC on the date of the transfer. If, on the 
date of the transfer, the transferor is a CFC that is not required to 
make a return of tax under Subtitle A of the Internal Revenue Code 
(including an information return) for the year of the transfer, the 
election statement is filed by including the following statement on or 
with the

[[Page 62072]]

timely filed original return (including extensions) of each one of the 
transferor's controlling U.S. shareholders, as defined in Sec.  1.964-
1(c)(5), for the taxable year within which the transfer occurred: 
``[insert name and tax identification number of controlling U.S. 
shareholder filing return] certifies that [insert name and tax 
identification number, if any, of transferor (the CFC)] and [insert 
name and tax identification number, if any, of transferee] elect to 
apply section 362(e)(2)(C) with respect to a transfer of property 
described in section 362(e)(2)(A) on [insert date(s) of transfer(s)]. 
[insert name(s) and tax identification number(s) of any other 
controlling U.S. shareholder(s) of the CFC, or, if none, state that 
there are no other controlling U.S. shareholders of the CFC].''
    (C) Transferor is not a U.S. person on the date of the transfer, a 
person otherwise required to file a U.S. return for the year of the 
transfer, or a CFC on the date of the transfer, and transferee is a 
U.S. person on the date of the transfer or a person otherwise required 
to file a U.S. return for the year of the transfer. If the transferor 
is not described in paragraph (c)(5)(ii)(A) or (c)(5)(ii)(B) of this 
section and the transferee is a U.S. person on the date of the transfer 
or otherwise required to make a return of tax under Subtitle A of the 
Internal Revenue Code (including an information return) for the year of 
the transfer, the election statement is filed by including the 
following statement on or with the transferee's timely filed original 
return (including extensions) for the taxable year in which the 
transfer occurred: ``[insert name and tax identification number of 
transferee] certifies that [insert name and tax identification number, 
if any, of transferor] and [insert name and tax identification number 
of transferee] elect to apply section 362(e)(2)(C) with respect to a 
transfer of property described in section 362(e)(2)(A) on [insert 
date(s) of transfer(s)].''
    (D) Transferor is not a U.S. person on the date of the transfer, a 
person otherwise required to file a U.S. return for the year of the 
transfer, or a CFC on the date of the transfer, and transferee is a CFC 
on the date of the transfer. If the transferor is not described in 
paragraph (c)(5)(ii)(A) or (c)(5)(ii)(B) of this section, and, on the 
date of the transfer, the transferee is a CFC that is not required to 
make a return of tax under Subtitle A of the Internal Revenue Code 
(including an information return) for the year of the transfer, the 
election statement is filed by including the following statement on or 
with the timely filed original return (including extensions) of each 
one of the transferee's controlling U.S. shareholders as defined in 
Sec.  1.964-1(c)(5) for the taxable year within which the transfer 
occurred: ``[insert name and tax identification number of controlling 
U.S. shareholder filing return] certifies that [insert name and tax 
identification number, if any, of transferor] and [insert name and tax 
identification number, if any, of transferee (the CFC)] elect to apply 
section 362(e)(2)(C) with respect to a transfer of property described 
in section 362(e)(2)(A) on [insert date(s) of transfer(s)]. [insert 
name(s) and tax identification number(s) of any other controlling U.S. 
shareholder(s) of the CFC, or, if none, state that there are no other 
controlling U.S. shareholders of the CFC].''
    (iii) Election where neither the transferor nor the transferee is a 
U.S. person on the date of the transfer, a person otherwise required to 
file a U.S. return for the year of the transfer, or a CFC on the date 
of the transfer. If the parties to a transfer to which section 
362(e)(2) applies are not described in any of the classifications set 
forth in paragraph (c)(5)(ii) of this section, then the election 
statement under this paragraph (c) is made as described in this 
paragraph (c)(5)(iii).
    (A) Transferor later becomes a U.S. person, a person otherwise 
required to file a U.S. return, or a CFC. If the transferor later 
becomes a U.S. person, a person otherwise required to make a return of 
tax under Subtitle A of the Internal Revenue Code (including an 
information return), or a CFC, an election statement under this 
paragraph (c) is filed as described in this paragraph (c)(5)(iii)(A).
    (1) If the transferor becomes a U.S. person or a person otherwise 
required to make a return of tax under Subtitle A of the Internal 
Revenue Code (including an information return), the election statement 
is filed by including the statement described in paragraph 
(c)(5)(ii)(A) of this section on or with the transferor's timely filed 
original return (including extensions) for the taxable year in which 
the transferor first becomes a U.S. person or a person otherwise 
required to make a return.
    (2) If the transferor becomes a CFC that is not required to make a 
return of tax under Subtitle A of the Internal Revenue Code (including 
an information return), the election statement is filed by including 
the statement described in paragraph (c)(5)(ii)(B) of this section on 
or with the timely filed original return (including extensions) of each 
one of the transferor's controlling U.S. shareholders, as defined in 
Sec.  1.964-1(c)(5), for the taxable year within which the transferor 
becomes a CFC.
    (B) Transferee later becomes a U.S. person, a person otherwise 
required to file a U.S. return, or a CFC. If the transferor is not 
described in paragraph (c)(5)(iii)(A) of this section, and the 
transferee later becomes a U.S. person, a person otherwise required to 
make a return of tax under Subtitle A of the Internal Revenue Code 
(including an information return), or a CFC, an election statement 
under this paragraph (c) is filed as described in this paragraph 
(c)(5)(iii)(B).
    (1) If the transferee becomes a U.S. person or a person otherwise 
required to make a return of tax under Subtitle A of the Internal 
Revenue Code (including an information return), the election statement 
is filed by including the statement described in paragraph 
(c)(5)(ii)(C) of this section on or with the transferee's timely filed 
original return (including extensions) for the taxable year in which 
the transferee first becomes required to make a return.
    (2) If the transferee becomes a CFC that is not required to make 
any return of tax under Subtitle A of the Internal Revenue Code 
(including an information return), the election statement is filed by 
including the statement described in paragraph (c)(5)(ii)(D) of this 
section on or with the timely filed original return (including 
extensions) of each one of the transferee's controlling U.S. 
shareholders as defined in Sec.  1.964-1(c)(5) for the taxable year 
within which the transferee becomes a CFC.
    (C) A U.S. person, a person otherwise required to file a U.S. 
return, or a CFC later acquires the transferred assets or transferee 
stock in a transferred basis transaction. If neither the transferor nor 
the transferee is described in paragraph (c)(5)(iii)(A) or 
(c)(5)(iii)(B) of this section and a U.S. person, a person otherwise 
required to make a return of tax under Subtitle A of the Internal 
Revenue Code (including an information return), or a CFC not required 
to make a return of tax under Subtitle A of the Internal Revenue Code 
(including an information return) later acquires, in a transferred 
basis transaction, any portion of the assets that were transferred in a 
prior transaction to which section 362(e)(2) applied (section 362(e)(2) 
assets) or stock of the transferee corporation received in such prior 
transaction (section 362(e)(2) stock), then the election statement 
under this paragraph (c) is filed as described in this paragraph 
(c)(5)(iii)(C).

[[Page 62073]]

    (1) If a U.S. person or a person otherwise required to make a 
return of tax under Subtitle A of the Internal Revenue Code (including 
an information return) later acquires, in a transferred basis 
transaction, any portion of the section 362(e)(2) assets or section 
362(e)(2) stock, the election statement is filed by including the 
following statement on or with such acquiror's timely filed original 
return (including extensions) for the taxable year in which the 
acquiror first acquires any portion of the section 362(e)(2) assets or 
section 362(e)(2) stock: ``[insert name and tax identification number 
of the acquiror] certifies that [insert name and tax identification 
number, if any, of transferor] and [insert name and tax identification 
number, if any, of transferee] elect to apply section 362(e)(2)(C) with 
respect to a transfer of property described in section 362(e)(2)(A) on 
[insert date(s) of transfer(s)].''
    (2) If no person described in paragraph (c)(5)(iii)(C)(1) of this 
section has acquired any portion of the section 362(e)(2) assets or 
section 362(e)(2) stock, and a CFC not required to make a return of tax 
under Subtitle A of the Internal Revenue Code (including an information 
return) later acquires, in a transferred basis transaction, any portion 
of the section 362(e)(2) assets or section 362(e)(2) stock, the 
election statement is filed by including the following statement on or 
with each of the CFC's controlling U.S. shareholders' timely filed 
original returns (including extensions) for the taxable year within 
which the CFC first acquires any portion of the section 362(e)(2) 
assets or section 362(e)(2) stock: ``[insert name and tax 
identification number of controlling U.S. shareholder filing return] 
certifies that [insert name and tax identification number, if any, of 
transferor] and [insert name and tax identification number, if any, of 
transferee] elect to apply section 362(e)(2)(C) with respect to a 
transfer of property described in section 362(e)(2)(A) on [insert 
date(s) of transfer(s)]. [insert name(s) and tax identification 
number(s) of any other controlling U.S. shareholder(s) of the CFC, or, 
if none, state that there are no other controlling U.S. shareholders of 
the CFC].''
    (6) Transfers by partnerships. If the transferor is a partnership, 
for purposes of applying section 705 (determination of basis of 
partner's interest), any reduction under this section to the 
transferor's basis in the stock received in exchange for the 
transferred property is treated as an expenditure of the partnership 
described in section 705(a)(2)(B).
    (7) Transfers by S corporations. If the transferor is an S 
corporation, for purposes of applying section 1367 (adjustments to 
basis of stock of shareholders, etc.), any reduction under this section 
to the transferor's basis in the stock received in exchange for the 
transferred property is treated as an expense of the S corporation 
described in section 1367(a)(2)(D).
    (d) Examples. The following examples illustrate paragraphs (a) 
through (c) of this section. Unless otherwise indicated, all 
transferred property is subject to tax under Subtitle A of the Internal 
Revenue Code in the hands of the transferor, and, accordingly, section 
362(e)(1) does not apply to the transaction. In addition, all assets 
are capital assets in the hands of the transferor and have been held 
for more than one year.

    Example 1. Property transfer qualifying under section 351. (i) 
Facts. Individual A owns Asset 1 with a basis of $90 and a fair 
market value of $60, and Asset 2 with a basis of basis of $110 and a 
fair market value of $120. In a transaction qualifying under section 
351, A transfers Asset 1 and Asset 2 to newly formed corporation X 
in exchange for all of the X common stock. A and X do not elect to 
apply section 362(e)(2)(C) to reduce A's basis in the X stock 
received.
    (ii) Analysis. Under section 362(a), X would otherwise receive 
Asset 1 and Asset 2 with an aggregate basis of $200 ($90+$110), 
which exceeds their aggregate fair market value of $180 ($60+$120). 
As a result, the assets have a net built-in loss of $20, and this 
section applies to the transfer. Under paragraph (b)(1) of this 
section, X reduces its basis in Asset 1 by $20 to $70 and, under 
section 362(a), takes a basis in Asset 2 of $110. Under section 
358(a), A receives X stock with a basis of $200.
    (iii) Election to apply section 362(e)(2)(C). The facts are the 
same as in paragraph (i) of this Example 1, except that A and X 
elect to apply section 362(e)(2)(C) to reduce A's basis in the X 
stock received. Under paragraph (c)(3) of this section, A reduces 
its basis in the X stock received by the amount X would have been 
required to reduce its basis in the transferred assets had the 
election to apply section 362(e)(2)(C) not been made. Accordingly, A 
receives X stock with an aggregate basis of $180, and, under section 
362(a), X receives Asset 1 with a basis of $90 and Asset 2 with a 
basis of $110.
    Example 2. Property transfer qualifying under section 351 and 
described in section 368(a)(1)(B). (i) Facts. Corporation P owns all 
of the outstanding stock of corporations S1 and S2. In a transaction 
qualifying under section 351 and described in section 368(a)(1)(B), 
P transfers all 10 shares of its S2 stock to S1 in exchange for an 
additional 10 shares of S1 voting stock. At the time of the 
transfer, each share of the S2 stock has a basis of $10 and a fair 
market value of $7. P and S1 do not elect to apply section 
362(e)(2)(C) to reduce P's basis in its S1 stock.
    (ii) Analysis. Under section 362, S1 would otherwise receive the 
10 shares of S2 stock with a basis of $10 per share, which exceeds 
their fair market value of $7 per share. As a result, the S2 stock 
has a net built-in loss of $30, and this section applies to the 
transfer. Under paragraph (b)(1) of this section, S1 reduces its 
basis in the S2 stock by $30 to $70. Under section 358(a), P 
receives the additional 10 shares of S1 stock with a basis of $10 
per share.
    (iii) Election under section 362(e)(2)(C). (A) The facts are the 
same as in paragraph (i) of this Example 2, except that P and S1 
elect to apply section 362(e)(2)(C) to reduce P's basis in its S1 
stock received. Under paragraph (c)(3) of this section, P reduces 
its basis in the S1 stock received by the amount S1 would have been 
required to reduce its basis in the transferred S2 stock had the 
election to apply section 362(e)(2)(C) not been made. Accordingly, 
under paragraph (c)(4) of this section, P receives the additional 10 
shares of S1 stock each with a basis of $7. Under section 362, S1 
receives the 10 shares of S2 stock each with a basis of $10.
    (B) The facts are the same as in paragraph (i) of this Example 
2, except that five shares of the S2 stock have a basis of $10 each, 
five shares have a basis of $5 each, and P and S1 elect to apply 
section 362(e)(2)(C) to reduce P's basis in its S1 stock. The $75 
((5 x $10) + (5 x $5)) aggregate basis in the S2 stock exceeds the 
$70 aggregate fair market value of the S2 stock, and this section 
applies to the transfer. Under paragraph (c)(3) of this section, P 
reduces its basis in the S1 stock received by the amount S1 would 
have been required to reduce its basis in the transferred S2 stock 
had the election to apply section 362(e)(2)(C) not been made. 
Accordingly, under paragraph (c)(4) of this section and Sec.  1.358-
2(a)(2)(viii), P receives the additional 10 shares of S1 stock each 
with a basis of $7. Under section 362, S1 receives five shares of 
the S2 stock with a basis of $10 each and five shares of the S2 
stock with a basis of $5 each.
    Example 3. Property transfer qualifying under section 351 and 
described in section 368(a)(1)(A). (i) Facts. Individual A owns all 
of the outstanding stock of corporation X and corporation Y, which 
owns Asset 1 with an adjusted basis of $250 and a fair market value 
of $210. A also owns Asset 2 with an adjusted basis of $120 and a 
fair market value of $130. In a transaction qualifying as a 
reorganization described in section 368(a)(1)(A), Y merges with and 
into X. Pursuant to the same plan, A transfers Asset 2 to X in 
exchange for additional X stock. Y's transfer of Asset 1 to X in the 
merger coupled with A's transfer of Asset 2 to X in exchange for X 
stock qualifies as a section 351 contribution.
    (ii) Analysis. Under paragraph (b)(2) of this section, the 
potential application of section 362(e)(2) is determined separately 
for each transferor. Y is treated as having transferred Asset 1 to X 
in exchange for X stock, and X would otherwise take Asset 1 with a 
basis of $250, which exceeds its fair market value of $210. As a 
result, Asset 1 has a built-in loss of $40. Under paragraph (b)(6) 
of this section, section 362(e)(2) does not apply to Y's transfer of 
property to X because Y distributes all of the X stock received in 
the exchange without recognizing gain or loss pursuant to section 
361(c), and, upon

[[Page 62074]]

completion of the transaction, no person holds X stock or any other 
asset with a basis determined in whole or in part by reference to 
Y's basis in the X stock received in the exchange. As a result, 
under section 362, X receives Asset 1 with a basis of $250. A's 
transfer of Asset 2 to X is not subject to section 362(e)(2) because 
X receives Asset 2 with a basis of $120, which is less than its fair 
market value of $130.
    Example 4. Property transfers qualifying under section 351 and 
described in section 368(a)(1)(D), followed by a section 355 
distribution. (i) Facts. Individual A and individual B each own 50 
percent of corporation X. X owns Asset 1 with an adjusted basis of 
$120 and a fair market value of $70, Asset 2 with an adjusted basis 
of $160 and a fair market value of $110, and Asset 3 with an 
adjusted basis of $220 and a fair market value of $240. In a 
transaction qualifying under section 351(a) and described in section 
368(a)(1)(D), X transfers Asset 1, Asset 2, and Asset 3 to Y, a 
newly formed corporation, in exchange for all of the Y stock, and 
then distributes all of the Y stock to A in exchange for all of A's 
X stock in a distribution qualifying under section 355. At the time 
of the transaction, A has no plan or intention to dispose of his Y 
stock, and B has no plan or intention to dispose of his X stock.
    (ii) Analysis. The aggregate adjusted basis of the properties 
transferred to Y ($120 + $160 + $220 = $500) exceeds their aggregate 
fair market value ($70 + $110 + $240 = $420). As a result, the 
assets have a total net built-in loss of $80. Under paragraph (b)(6) 
of this section, section 362(e)(2) does not apply to this transfer 
of property because X distributes all of the Y stock received in the 
exchange without recognizing gain or loss under section 361(c), and, 
upon completion of the transaction, no person holds Y stock or any 
other asset with a basis determined in whole or in part by reference 
to X's basis in the Y stock received in the exchange. A's basis in 
the Y stock is determined under section 358 by reference to his 
basis in the X stock he surrenders.
    (iii) Section 355(e). (A) The facts are the same as in paragraph 
(i) of this Example 4, except that, one year after the section 355 
distribution, Y is acquired pursuant to a plan, resulting in the 
application of section 355(e) to the transaction. X and Y do not 
elect to apply section 362(e)(2)(C).
    (B) Analysis. Due to the application of section 355(e), section 
361(c) will not apply and X will not be granted nonrecognition 
treatment on the distribution of the Y stock. As a result, paragraph 
(b)(6) of this section does not apply, and section 362(e)(2) applies 
to X's transfer of assets to Y. Under paragraph (b)(1) of this 
section, Y reduces its basis in Asset 1 and Asset 2 by the amount of 
the net built-in loss in the transferred assets, or $80 ($500 - 
$420). The $80 basis reduction is allocated between Asset 1 and 
Asset 2 in proportion to their respective built-in losses. Prior to 
reduction, Asset 1 had a built-in loss of $50 ($120 - $70), and 
Asset 2 had a built-in loss of $50 ($160 - $110). As a result, the 
basis of Asset 1 is reduced by $40 (50/100 x $80), and the basis of 
Asset 2 is reduced by $40 (50/100 x $80), and Y receives Asset 1 
with a basis of $80 ($120 - $40) and Asset 2 with a basis of $120 
($160 - $40).
    (iv) Retained stock and securities without a section 
362(e)(2)(C) election. (A) The facts are the same as in paragraph 
(i) of this Example 4, except that X transfers Asset 1, Asset 2, and 
Asset 3 to Y in exchange for an equal amount of Y stock and Y 
securities. For a valid business purpose, X retains Y stock and Y 
securities each worth 1 percent of the total consideration. X and Y 
do not elect to apply section 362(e)(2)(C).
    (B) Analysis. The aggregate basis of the properties transferred 
($120 + $160 + $220 = $500) exceeds their aggregate fair market 
value ($70 + $110 + $240 = $420) by $80 ($500 - $420), and this 
section applies to the transfer. Under paragraph (b)(6) of this 
section, section 362(e)(2) applies to X's transfer of assets to Y in 
exchange for the Y stock and the Y securities to the extent X does 
not distribute the Y stock and Y securities without the recognition 
of gain or loss. Accordingly, section 362(e)(2)(A) applies to the 
extent property was exchanged for the retained Y stock and Y 
securities (2 percent of the total). Under paragraph (b)(1) of this 
section, Y reduces its basis in Asset 1 and in Asset 2 by 2 percent 
of the amount of the net built-in loss in the transferred assets 
($80), or $1.60. The $1.60 basis reduction is allocated between 
Asset 1 and Asset 2 in proportion to their respective built-in 
losses before reduction under paragraph (b)(1) of this section. 
Prior to reduction, Asset 1 had a built-in loss of $50 ($120 - $70), 
and Asset 2 had a built-in loss of $50 ($160 - $110). As a result, 
the basis of Asset 1 is reduced by $.80 (50/100 x $1.60), the basis 
of Asset 2 is reduced by $.80 (50/100 x $1.60), and Y receives Asset 
1 with a basis of $119.20 ($120 - $.80) and Asset 2 with a basis of 
$159.20 ($160 - $.80).
    (v) Retained stock and securities with a section 362(e)(2)(C) 
election. (A) The facts are the same as in paragraph (iv)(A) of this 
Example 4, except that X and Y elect to apply section 362(e)(2)(C) 
to reduce X's basis in its retained Y stock and retained Y 
securities.
    (B) Analysis. Under paragraph (b)(6) of this section, section 
362(e)(2) applies to X's transfer of assets to Y in exchange for the 
Y stock and the Y securities to the extent X does not distribute the 
Y stock and Y securities without the recognition of gain or loss. 
Under paragraph (c) of this section, the election to apply section 
362(e)(2)(C) applies to both the retained Y stock and the retained Y 
securities. Accordingly, under paragraph (c)(3) of this section, X 
reduces its basis in the retained Y stock and the retained Y 
securities by the amount Y would have been required to reduce its 
basis in the transferred assets had the election to apply section 
362(e)(2)(C) not been made. As described in paragraph (iv)(B) of 
this Example 4, under paragraphs (b)(1) and (b)(6) of this section, 
Y would have been required to reduce its basis in the transferred 
assets by $1.60. Accordingly, X is required to reduce its basis in 
the retained Y stock and Y securities by $1.60, and, under paragraph 
(c)(4) of this section, this $1.60 basis reduction is allocated 
between the retained Y stock and Y securities in proportion to fair 
market value. Because X retained Y stock and Y securities with equal 
values, X holds the retained Y stock with an adjusted basis of $1.70 
((($500/2) x .01) - $.80) and the retained Y securities with an 
adjusted basis of $1.70 ((($500/2) x .01) - $.80).
    Example 5. Transfer of contingent liabilities subject to section 
358(h)(2)(A) with section 362(e)(2)(C) election. (i) Facts. 
Corporation P owns Asset 1 with a basis of $800 and a fair market 
value of $700. Asset 1 constitutes a trade or business for purposes 
of section 358(h)(2)(A). Contingent liabilities of $200 are 
associated with the Asset 1 business. P transfers Asset 1 to newly 
formed corporation S in exchange for all of the S stock and 
assumption of the contingent liabilities in a transaction qualifying 
under section 351. P and S elect to apply section 362(e)(2)(C).
    (ii) Analysis. Under section 362(a), S would otherwise receive 
Asset 1 with a basis of $800, which exceeds it fair market value of 
$700. As a result, Asset 1 has a net built-in loss of $100, and this 
section applies to the transfer. Under paragraph (c)(3) of this 
section, P reduces its basis in the S stock received by the amount S 
would have been required to reduce its basis in Asset 1 had the 
election to apply section 362(e)(2)(C) not been made ($100). 
Accordingly, A receives S stock with an aggregate basis of $700, 
and, under section 362(a), S receives Asset 1 with a basis of $800.
    Example 6. Property transfer qualifying under section 351 with 
boot. (i) Facts. Individual A owns Asset 1 with a basis of $80 and a 
fair market value of $100, and Asset 2 with a basis of $30 and a 
fair market value of $25. In a transaction qualifying under section 
351, A transfers Asset 1 and Asset 2 to newly formed corporation N 
in exchange for 10 shares of N stock and $25. A and N do not elect 
to apply section 362(e)(2)(C) to reduce A's basis in the N stock 
received.
    (ii) Analysis. Under paragraph (b)(4)(iii) of this section, for 
purposes of determining whether the transferred property has a net 
built-in loss in the hands of the transferee, the transferee's basis 
in the transferred property must be adjusted for any gain recognized 
by the transferor on the transfer. Section 351(b) requires 
transferors in transactions otherwise qualifying under section 
351(a) for nonrecognition treatment to recognize gain (but not loss) 
to the extent the transferor receives other property or money in 
addition to the stock permitted to be received. For purposes of 
computing the amount of gain recognized under section 351(b), the 
consideration is allocated pro rata among the transferred properties 
according to their fair market values. As a result, to compute the 
amount of gain recognized on the transfer, A is treated as having 
received eight shares of N stock and $20 in exchange for Asset 1, 
and two shares of N stock and $5 in exchange for Asset 2. Under 
section 351(b), A must recognize $20 of gain for the cash received 
in exchange for Asset 1. Thus, under section 362(a), N would 
otherwise have a basis of $100 in Asset 1 and $30 in Asset 2. N's 
total basis in Asset 1 and Asset 2 of $130 ($100 + $30) would exceed 
the total fair market value of Asset 1 and Asset 2 of $125 ($100 + 
$25). As a result, this section

[[Page 62075]]

applies to the transfer. Under paragraph (b)(1) of this section, N 
reduces its basis in Asset 2 by $5 to $25 and, under section 362(a), 
takes a basis in Asset 1 of $100. Under section 358(a), A receives N 
stock with a basis of $105.
    Example 7. Property transfer subject to both sections 362(e)(1) 
and 362(e)(2). (i) Facts. Foreign corporation FP transfers Asset 1 
and Asset 2 to a domestic corporation DS in a transaction that 
qualifies under section 351. Asset 1 is not property described in 
section 362(e)(1)(B) and has a basis of $80 and a fair market value 
of $50. Asset 2 is property described in section 362(e)(1)(B) and 
has a basis of $120 and a value of $110. Section 367(b) does not 
apply to the transfer of Asset 1 or Asset 2.
    (ii) Analysis. Under paragraphs (b)(1) and (b)(3) of this 
section, a transfer is described in section 362(e)(1), and thus not 
subject to this section, only if and to the extent there is a 
transfer of property described in section 362(e)(1)(B) that 
otherwise would have a net built-in loss in the hands of the 
transferee. Because Asset 2 is property described in section 
362(e)(1)(B) and DS would otherwise receive Asset 2 with a basis of 
$120 and a value of $110, FP's transfer of property to DS is 
described in section 362(e)(1) only to the extent of the transfer of 
Asset 2. Asset 1 is not property described in section 362(e)(1)(B), 
and under section 362(a), DS would receive Asset 1 with a basis 
($80) in excess of its fair market value ($50). Accordingly, this 
section applies solely to the transfer of Asset 1. Under paragraph 
(b)(1) of this section, DS reduces its basis in Asset 1 by $30 to 
$50. Under section 358(a), FP receives the DS stock with a basis of 
$200.
    Example 8. Section 304 sale of built-in loss stock. (i) Facts. 
Individual A owns all the stock of corporation X and corporation Y. 
A sells all his X stock to Y for $60. Under section 304, A is 
treated as though he transferred the X stock to Y in exchange for Y 
stock in a transaction to which section 351 applies. Then, Y is 
treated as redeeming the Y stock it was treated as having issued to 
A in the section 351 transaction. At the time of the transaction, A 
holds X stock with a basis of $90 and a fair market value of $60. A 
and Y do not elect to apply section 362(e)(2)(C) to reduce A's basis 
in the Y stock deemed received.
    (ii) Analysis. Under section 362(a), Y would otherwise receive X 
stock with an aggregate basis of $90, which exceeds its aggregate 
fair market value of $60. As a result, the X stock has a net built-
in loss of $30, and, under paragraph (b)(1) of this section, Y 
reduces its basis in the X stock received by $30 to $60. Under 
section 358(a), A receives the deemed issued Y stock with a basis of 
$90.

    (e) Effective date. This section applies to transactions occurring 
after the date these regulations are published as final regulations in 
the Federal Register.
    Par. 5. Section 1.705-1(a)(9) is added to read as follows:


Sec.  1.705-1  Determination of basis of partner's interest.

    (a) * * *
    (9) For basis adjustments necessary to coordinate sections 705 and 
362(e)(2), see Sec.  1.362-4(c)(6).
* * * * *
    Par. 6. In Sec.  1.1367-1, a new sentence is added at the end of 
paragraph (c)(2) to read as follows:


Sec.  1.1367-1  Adjustments to basis of shareholder's stock in an S 
corporation.

* * * * *
    (c) * * *
    (2) * * * For basis adjustments necessary to coordinate sections 
1367 and 362(e)(2), see Sec.  1.362-4(c)(7).
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E6-17649 Filed 10-20-06; 8:45 am]
BILLING CODE 4830-01-P