[Federal Register Volume 74, Number 12 (Wednesday, January 21, 2009)]
[Proposed Rules]
[Pages 3509-3526]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-1100]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-143686-07]
RIN 1545-BH35


The Allocation of Consideration and Allocation and Recovery of 
Basis in Transactions Involving Corporate Stock or Securities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under sections 
301, 302, 304, 351, 354, 356, 358, 368, 861, 1001, and 1016 of the 
Internal Revenue Code (Code). The proposed regulations provide guidance 
regarding the recovery of stock basis in distributions under section 
301 and transactions that are treated as dividends to which section 301 
applies, as well as guidance regarding the determination of gain and 
the basis of stock or securities received in exchange for, or with 
respect to, stock or securities in certain transactions. The proposed 
regulations affect shareholders and security holders of corporations. 
These proposed regulations are necessary to provide such shareholders 
and security holders with guidance regarding the allocation and 
recovery of basis on distributions of property.

DATES: Written or electronic comments, and a request for a public 
hearing, must be received by April 21, 2009.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-143686-07), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
143686-07), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at www.regulations.gov (IRSREG-143686-07).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations 
under sections 301, 302, and 304, Theresa M. Kolish, (202) 622-7530; 
concerning the proposed regulations under sections 351, 354, 356, 358, 
368, 1001, and 1016, Rebecca O. Burch, (202) 622-7550; concerning the 
proposed regulations under section 861, Jeffrey L. Parry, (202) 622-
4476; concerning submission of comments or to request a hearing, 
Richard Hurst (202) 622-7180 (not toll free numbers).

Background

    The primary objective of these proposed regulations is to provide a 
single model for stock basis recovery by a shareholder that receives a 
constructive or actual distribution to which section 301 applies and a 
single model for sale and exchange transactions to which section 302(a) 
applies, including certain elements of a reorganization exchange. 
Further to this objective, these proposed regulations define the scope 
of the exchange that must be analyzed under particular Code provisions, 
and provide a methodology for determining gain realized under section 
356 and stock basis under section 358.
    In addition, these proposed regulations respond to comments 
received by the IRS and Treasury Department regarding the current 
section 358 regulations, such as suggestions to expand the tracing 
rules to stock transfers that are subject to section 351 but do not 
qualify as reorganizations, questions regarding whether (and, if so, to 
what extent) shareholder elections constitute terms of an exchange, and 
whether the terms of an exchange control for purposes of qualifying a 
transaction as a reorganization under section 368. Finally, these 
proposed regulations include amendments to the section 304 regulations 
that import the statutory amendments to that section. See 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

[[Page 3510]]

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).

Explanation of Provisions

I. Introduction--Exchanges and Distributions to Which Sections 301 and 
302 Apply

    Section 301 provides rules for the treatment of a distribution with 
respect to stock but does not specify how to identify the shares upon 
which a distribution is made. Furthermore, the tax law does not provide 
rules concerning whether a shareholder recovers its stock basis in the 
aggregate, or alternatively, whether a shareholder is required to 
recover stock basis share-by-share. Finally, the tax law does not 
provide specifically that transactions treated as section 301 
distributions (i.e., redemptions under section 302(d), certain section 
304 transactions, and certain reorganizations) should be subject to the 
same rules as actual section 301 distributions. In the reorganization 
context, the Code provides consequences resulting from different types 
of exchanges, but does not specify whether the exchange is based on a 
shareholder's aggregate stock holdings, or alternatively, based on 
particular elements of the overall exchange.
    Rules related to stock basis recovery and stock basis 
determinations have evolved independently over many years on a 
transactional basis. Ad hoc development of these authorities has lead 
to the possibility of variant treatment of economically similar 
transactions to which section 301 or 302(a) applies either directly or 
through the operation of other Code provisions. Moreover, because there 
has not been a comprehensive review of these issues, many questions 
lack definitive answers. Prior guidance attempted to address particular 
areas of uncertainty within the subject matter of basis recovery and 
basis identification. Without the benefit of addressing all related 
issues, however, certain of this prior guidance was needed 
reconsidered. See REG-150313-01. Other guidance built the framework for 
basis identification that has encouraged the development of these 
proposed regulations.
    Building on themes developed in Sec.  1.358-2 and comments received 
from the tax community, this proposal is intended to be a comprehensive 
approach to stock basis recovery and stock basis identification to 
produce consistent results among economically similar transactions, 
regardless of the transaction type or the specific Code provision that 
results in the application of section 301 or 302(a).
    The cornerstone of this proposal is that a share of stock is the 
basic unit of property that can be disposed of and, accordingly, the 
results of a transaction should generally derive from the consideration 
received in respect of that share. This guiding principle has section 
1012 as its underpinning and has become fundamental to the tax 
treatment of shareholders, regardless of the specific nature of a 
shareholder's exchange. See Sec.  1.358-2 and Sec.  1.367(b)-13. A 
corollary to this basic premise is that a reorganization exchange is 
not an event that justifies alteration of a shareholder's tax position 
beyond what is necessary to reflect the results of the reorganization.
    To harmonize the tax treatment of economically similar 
transactions, these proposed regulations adopt a single model for 
section 301 distributions (dividend equivalent transactions) and a 
single model for sale or exchange transactions to which section 302(a) 
applies (non-dividend equivalent transactions), regardless of whether 
section 301 or section 302(a) applies directly or by reason of section 
302(d), 304 or 356.

II. Distributions With Respect to Stock and Dividend Equivalent 
Transactions

A. Section 301 Distributions
    Consistent with the fundamental notion that a share of stock is the 
basic unit of property, the results of a section 301 distribution 
should derive from the consideration received in respect of each share 
of stock, notwithstanding designations otherwise. Johnson v. United 
States, 435 F.2d 1257 (4th Cir. 1971). Accordingly, these proposed 
regulations treat a section 301 distribution as received on a pro rata, 
share-by-share basis with respect to the class of stock upon which the 
distribution is made. Thus, a distribution that is not a dividend 
within the meaning of section 301(c)(1) can result in gain with respect 
to some shares of a class while other shares have unrecovered basis.
B. Dividend Equivalent Redemptions
    To promote consistency among transactions treated as section 301 
distributions under the Code, these proposed regulations apply the same 
basis recovery rules described above to both dividend equivalent 
redemptions and certain section 304 transactions. Accordingly, under 
these proposed regulations, a dividend equivalent redemption results in 
a pro rata, share-by-share distribution to all shares of the ``redeemed 
class'' held by the redeemed shareholder immediately before the 
redemption. The proposed regulations define the term ``redeemed class'' 
to mean all of the shares of that class held by the redeemed 
shareholder. Similar to an actual section 301 distribution, the 
proportional approach to basis recovery in dividend equivalent 
redemptions can produce gain with respect to some shares while other 
shares have unrecovered basis.
    The constructive section 301 distribution is limited to the shares 
of the redeemed class (instead of constructing a pro rata distribution 
among all shares of various classes held by the redeemed shareholder) 
because different classes of stock have distinct legal entitlements 
that are respected for federal income tax purposes. H.K. Porter Co., 87 
T.C. 689 (1986); Comm'r v. Spaulding Bakeries, 252 F.2d 693 (2d Cir. 
1958). Accordingly, a constructive section 301 distribution is 
conformed to an actual section 301 distribution by identifying those 
shares with respect to which an actual section 301 distribution would 
have been received, and by reducing the basis of only those shares.
i. Basis Adjustments in Dividend Equivalent Redemptions if Less Than 
All of the Shares of a Single Class Held by the Taxpayer Are Redeemed
    If less than all of the shares of a class of stock held by the 
taxpayer are redeemed, the proposed regulations provide that in a 
hypothetical recapitalization described in section 368(a)(1)(E), the 
redeemed shareholder is deemed to exchange all its shares in the class, 
including the redeemed shares, for the actual number of shares held 
after the redemption transaction. The tracing rules of the section 358 
regulations apply to preserve the basis of the shares exchanged in the 
recapitalization in the remaining shares of the redeemed class held by 
the shareholder. Thus, under these proposed regulations, a dividend 
equivalent redemption is generally treated in the same manner, and its 
results are the same as, a section 301 distribution in which no shares 
were cancelled.
ii. Basis Recovery in Dividend Equivalent Redemptions in Which the 
Taxpayer Surrenders All of Its Shares in a Single Class
    Under current law, if all of the shares of a single class held by a 
shareholder are redeemed in a dividend equivalent redemption, any 
unrecovered basis in the redeemed shares is permitted to shift to other 
shares in certain circumstances. See Sec.  1.302-2(c). The

[[Page 3511]]

IRS and Treasury Department believe that the shifting of stock basis is 
inconsistent with the fundamental principle that each share is a 
separate unit of property, and can lead to inappropriate results. 
Accordingly, these proposed regulations do not permit the shifting of 
basis to other shares held (directly or by attribution) by the redeemed 
shareholder. Instead, the proposed regulations preserve the tax 
consequences of the unrecovered basis for the redeemed shareholder by 
treating the amount of the unrecovered basis as a deferred loss of the 
redeemed shareholder that can be accessed when the conditions of 
sections 302(b)(1), (2), or (3) are satisfied, or alternatively, when 
all the shares of the issuing corporation (or its successor) become 
worthless within the meaning of section 165(g).
C. Dividend Equivalent Reorganization Exchanges
    If, pursuant to a reorganization, a shareholder receives qualifying 
property and boot in exchange for its target corporation stock, the tax 
consequences of the receipt of the boot under these proposed 
regulations will depend upon whether the reorganization exchange is 
dividend equivalent or not. See section III. of this Preamble for a 
description of the proposed rules that would apply if the 
reorganization is not dividend equivalent.
    In general, the determination of whether an exchange has the effect 
of the distribution of a dividend for purposes of section 356(a)(2) is 
determined by examining the effect of the shareholder's ``overall 
exchange.'' Commissioner v. Clark, 489 U.S. 726, 738 (1989). Thus, the 
key to this determination is the scope of the exchange. For example, if 
the shareholder exchanges shares of preferred stock solely for boot and 
shares of common stock solely for qualifying property pursuant to a 
plan of reorganization, is the determination of whether the exchange of 
the preferred stock for boot is dividend equivalent based solely on 
that particular exchange or on the overall exchange of the preferred 
and common stock for the qualifying property and the boot? The same 
question would arise with respect to each particular exchange if the 
shareholder exchanged the preferred and common stock for a combination 
of qualifying property and boot. The Clark decision examined a 
reorganization exchange involving a single class of stock, and does not 
provide guidance in the context of multiple classes of stock.
    In the case of a section 302 redemption, the exchanging shareholder 
determines dividend equivalency based on all the facts and 
circumstances. See Zenz v. Quinlivan, 213 F.2d 914 (C.A.6 1954). To 
promote consistency between sale or exchange transactions, these 
proposed regulations provide that the overall reorganization exchange 
shall be taken into account in determining whether a particular 
exchange is dividend equivalent. Thus, a shareholder that exchanges a 
class of stock solely for boot and another class of stock solely for 
nonqualifying property shall consider the overall exchange (the 
exchange of the two classes of stock for boot and qualifying property) 
in determining whether each particular exchange is dividend equivalent.
    If it is determined that a reorganization exchange is dividend 
equivalent, because different classes of stock have distinct legal 
entitlements that are respected for federal income tax purposes, the 
proposed regulations provide that an exchange of a class of stock 
solely of boot is an exchange to which section 302(d) (and not section 
356(a)(2)) applies.
    To ensure similar tax treatment of dividend equivalent 
reorganization exchanges and dividend equivalent redemptions, if the 
reorganization exchange is dividend equivalent the proposed regulations 
limit the ability of the exchanging shareholder to specify the terms of 
the exchange. Specifically, if the shareholder receives more than one 
class of stock or surrenders one class of stock and securities, the 
shareholder may specify the terms of the exchange between the classes 
of stock surrendered (or between one or more classes of stock and 
securities surrendered), provided the designation is economically 
reasonable, but not between particular shares of the same class of 
stock.
    As with the redemption of shares of a redeemed class in a dividend 
equivalent redemption, a shareholder's receipt solely of boot with 
respect to a class of stock in a reorganization exchange is treated as 
received pro rata, on a share-by-share basis, with respect to each 
share in the class--under the principles of Johnson, the shareholder 
cannot specify that the boot is received with respect to particular 
shares within the class. Consequently, such an exchange could result in 
gain recognition with respect to some shares while other shares in the 
class could have recovered basis.
    In formulating the proposed regulations, the IRS and Treasury 
Department considered different alternatives. For example, in a 
dividend equivalent reorganization exchange pursuant to section 
356(a)(2), the IRS and Treasury Department considered whether gain 
realized with respect to a class should be determined in the aggregate 
(for example, with respect to all shares within a class). Under this 
approach, no gain would be realized with respect to a class that has a 
block of built-in gain stock and block of built-in loss stock where the 
built-in loss is at least equal to the built-in gain. The IRS and 
Treasury Department rejected such an approach because it would 
contradict the fundamental principle that a share is a discrete unit of 
property, and also would compromise the principle that a reorganization 
exchange is not an event that justifies stock basis averaging. The IRS 
and Treasury Department also considered eliminating a shareholder's 
ability to specify the terms of a dividend equivalent reorganization 
exchange based on the premise that under Johnson, all consideration 
received in such an exchange should be considered received pro rata 
among all shares, regardless of whether more than one class is 
surrendered. The IRS and Treasury Department rejected this approach in 
favor of the approach of the proposed regulations that is analogous to 
the proposed treatment of dividend equivalent redemptions, under which 
each share of the redeemed class is treated as receiving a pro rata 
share of the proceeds, and shares outside of the redeemed class are not 
treated as receiving any part of the distribution.
D. Special Rules Related to Apportionment of Interest and Other 
Expenses
    Under section 864(e), taxpayers apportion interest expense between 
statutory and residual groupings on the basis of the relative values of 
their assets in each grouping. For this purpose, taxpayers may choose 
to value their assets using either fair market value or tax book value 
(adjusted basis). 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 redeemed class owned by 
the redeemed shareholder, any shares that are not in the redeemed 
class, or any shares owned by certain affiliated corporations shall be 
increased by the amount of the unrecovered basis of redeemed shares. 
Thus, under the proposed regulations, the interest expense allocation 
and apportionment consequences of a dividend equivalent redemption are 
the same as an actual section 301 distribution.

[[Page 3512]]

E. Section 1059
    Section 1059(a) provides that if a corporation receives an 
extraordinary dividend with respect to any share of stock and such 
corporation has not held such stock for more than two years before the 
dividend announcement date, then the corporation's basis in such stock 
shall be reduced (but not below zero) by the non-taxed portion of such 
dividends.
    Except as provided in regulations, in the case of any redemption of 
stock which would not have been treated (in whole or in part) as a 
dividend if any options had not been taken into account under section 
318(a)(4), or section 304(a) had not applied, any amount treated as a 
dividend is treated as an extraordinary dividend, without regard to the 
taxpayer's holding period in the stock. Section 1059(e)(1)(A)(iii). In 
the case of these types of redemptions, section 1059(e)(1)(A) (flush 
language) provides that only the basis of the stock redeemed shall be 
taken into account under section 1059(a). These proposed regulations do 
not affect the basis reduction provided for in section 1059(e)(1)(A) if 
section 1059(e)(1)(A)(iii) otherwise applies. Accordingly, to the 
extent of an extraordinary dividend described in section 
1059(e)(1)(A)(iii), a redeeming shareholder would first reduce basis as 
prescribed by section 1059(e)(1)(A). These proposed regulations would 
then apply to the extent the distribution is not a dividend within the 
meaning of section 301(c)(1).
F. Redemptions of Stock Held by Partnerships, Trusts, and S 
Corporations
    The treatment of unrecovered basis as a deferred loss raises 
special issues where the redeemed shareholder is an S corporation, a 
partnership, or a trust (each a flow-through entity). These proposed 
regulations reserve with respect to the issues relating to redeemed 
shareholders that are flow-through entities pending further study and 
comment. The primary issue under study is whether an ``outside'' basis 
adjustment that reflects the deferred loss should occur at the time of 
the dividend equivalent redemption, or alternatively, when there is an 
inclusion date with respect to the deduction.
    In general, a deferred loss is reflected in the outside basis of an 
interest in a flow-through entity when the deduction can be accessed by 
the entity. Accordingly, as a general matter, disconformity can exist 
between inside attributes and outside basis where an inside attribute 
is a deferred loss. Conversely, a net operating loss of a flow-through 
entity reduces the outside basis of an interest in the entity in the 
year that the net operating loss arises.
    Although disconformity generally can exist where a flow-through 
entity has a deferred loss, the IRS and Treasury Department are 
concerned that deferred losses arising from unrecovered basis presents 
an opportunity to separate the deferred loss from the dividend income 
resulting from the redemption. The IRS and Treasury Department question 
whether such a separation would be appropriate, and believe that 
treating the deferred loss as a net operating loss in the year of the 
redemption for basis adjustment purposes may be the better approach. 
However, the IRS and Treasury Department acknowledge that it may be 
inappropriate to require the owners of a flow-through entity to reduce 
outside basis before the deferred loss can be accessed, simply because 
the owners of the flow-through entity cannot access the deferred loss. 
The IRS and Treasury Department request comments on this issue.
    Flow-through entities also present the question of when it is 
appropriate to treat an owner of the flow-through entity as the 
redeemed shareholder, and when it is appropriate to treat the flow-
through entity itself as the redeemed shareholder. For example, where 
the owner completely divests of its interest in the flow-through 
entity, it may be appropriate to treat the owner as the redeemed 
shareholder for determining whether the sale of the flow-through entity 
interest is an inclusion date with respect to that owner. This 
treatment may be more appropriate if the deferred loss is treated as a 
net operating loss that already has reduced the outside basis of the 
entity's owner. Conversely, if the deferred loss is not treated as a 
net operating loss, it may be more appropriate to treat the flow-
through entity as the redeemed shareholder in all cases. The IRS and 
Treasury Department request comments on this issue.
G. Consolidated Groups and Basis Recovery in Dividend Equivalent 
Redemptions
    The IRS and Treasury Department continue to study the issues raised 
when a redeemed shareholder with a deferred loss files a consolidated 
return. The IRS and Treasury Department believe that certain of the 
concerns raised by REG-150313-01 are addressed in these proposed 
regulations by the deemed recapitalization mechanic described in 
section II.B.i. of this Preamble.

III. Redemptions Treated as a Sale or Exchange Pursuant to Section 
302(a)

A. In General
    Under current law for redemptions characterized under section 
302(a), a shareholder that owns shares of stock with different bases 
can decide whether to surrender for redemption high basis shares, low 
basis shares or any combination thereof. See Sec.  1.1012-1(c). 
Consistent with treating a share as a discrete unit of property, the 
proposed regulations do not limit this electivity. Additionally, as 
further discussed below, these proposed regulations affirm the ability 
of a shareholder to specify the terms of a reorganization exchange 
where the receipt of boot results in sale or exchange treatment.
B. Reorganization Exchanges That Result in Sale or Exchange Treatment
    If it is determined that the reorganization exchange is not 
dividend equivalent (as described in section II.C. of this Preamble), 
section 302(a) will apply to the extent shares are exchanged solely for 
boot. Just as a shareholder can elect to surrender high basis shares, 
low basis shares or any combination thereof in a non-dividend 
equivalent redemption, a shareholder engaging in a reorganization 
exchange that is not dividend equivalent can specify the receipt solely 
of boot for a share, provided that the terms of the exchange are 
economically reasonable. In such case, the shareholder will recognize 
gain or loss with respect to that share pursuant to section 302(a), and 
section 356(a)(1) will not apply.

IV. Extension of Tracing Principles To Determine Basis in Certain Stock 
Transfers That Are Not Reorganizations, and Other Proposals in Response 
to Specific Comments

A. Application of Tracing Principles to Certain Section 351 Exchanges 
and Capital
    The current section 358 regulations apply tracing principles to 
determine the basis of stock received in a section 351 exchange only 
where the section 351 exchange also qualifies as a reorganization and 
no liabilities was assumed in the exchange. The principal reason for 
this limitation is the interaction of the basis tracing rules with the 
aggregate approach to gain determination under section 357(c). The IRS 
and Treasury Department continue to study this issue, but have 
concluded that the resolution of this issue is not necessary to broaden 
the application of the tracing rules to transfers of stock in section 
351 exchanges in which no

[[Page 3513]]

liabilities are assumed. Thus, for example, in an exchange to which 
section 351 applies where the transferor transfers two blocks of stock 
with disparate basis and other property, the separate bases will be 
preserved under section 358, provided that liabilities are not assumed 
in the exchange.
    In addition, these proposed regulations incorporate the deemed 
issuance and recapitalization approach of the current section 358 
regulations to section 351 exchanges to preserve basis if insufficient 
shares, or no shares at all, are actually issued in the exchange. These 
proposed regulations also extend the deemed issuance and 
recapitalization approach to shareholder capital contributions to which 
section 118 applies.
B. Miscellaneous
    The IRS and Treasury Department have received a number of comments 
on the current section 358 regulations. These proposed regulations make 
a number of clarifying, but nonsubstantive, modifications to the 
current section 358 regulations. Specifically, the proposed regulations 
add headings throughout the existing final Sec. Sec.  1.358-1 and 
1.358-2 regulations without substantive change. In addition, the 
proposed regulations address the following comments received with 
respect to the current section 358 regulations.
    Commentators questioned how shareholder elections factor into the 
terms of the exchange. These proposed regulations include two new 
examples illustrating the effect of such elections.
    Commentators questioned the effect of the terms of an exchange on 
the determination of whether a transaction qualifies as a 
reorganization, and therefore is not subject to the general rule of 
section 1001. These proposed regulations include cross-references in 
the regulations under sections 368 and 1001 to clarify that, to the 
extent the terms of the exchange specify that a particular property is 
received in exchange for a particular property, such terms shall 
control for purposes of determining whether a transaction qualifies as 
a reorganization provided such terms are economically reasonable.
    Finally, in addition to provisions relating to the determination of 
basis, these proposed regulations add a rule that addresses certain 
issues considered in Rev. Rul. 68-55 (1968-1 CB 140). Specifically, 
consistent with Rev. Rul. 68-55, these regulations provide that, for 
purposes of determining gain under section 351(b), the fair market 
value of each category of consideration received in a section 351 
exchange is allocated between the transferred assets in based on 
relative fair market values.

V. Specifically Requested Comments

    In addition to the comments requested throughout this Preamble, the 
IRS and Treasury request comments on the following areas.
    The proposed regulations under section 302 do not apply to a 
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 unrecovered basis of redeemed 
section 306 stock is added to the basis of the stock with respect to 
which the section 306 stock was distributed. The IRS and Treasury 
Department request comments on whether such treatment is appropriate or 
whether an alternative regime should apply when such a section 306(c) 
redemption is treated as a section 301 distribution.
    Comments are also requested regarding whether, after a section 355 
pro rata split-up, the controlled corporations are the same as or 
different from the distributing corporation for purposes of determining 
whether the date of distribution would be an inclusion date for a 
deferred loss attributable to unrecovered basis.
    Finally, the IRS and Treasury Department recognize that the 
proposed regulations may not address all related issues arising in all 
cash ``D'' reorganizations. Specifically, these proposed regulations 
may heighten the importance of whether the nominal share deemed issued 
in such a reorganization is received in respect of particular shares 
surrendered by the exchanging shareholder. The IRS and Treasury 
Department request comments with respect to this issue.

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. Further, it 
is hereby certified that these proposed regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the fact that these regulations provide 
clarifying guidance of existing law and do not create additional 
obligations for, or impose an economic impact on small entities. 
Accordingly, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f) of the Code, 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. All comments will be available for public inspection and copying. 
If a public hearing is scheduled, notice of the date, time, and place 
for the public hearing will be published in the Federal Register.

Drafting Information

    The principal authors of these regulations are Theresa M. Kolish 
and Rebecca O. Burch of the Office of Associate Chief Counsel 
(Corporate). Other personnel from offices of the IRS and Treasury 
Department participated in their development.

Availability of IRS Documents

    IRS revenue rulings, procedures, and notices cited in this preamble 
are made available by the Superintendent of Documents, U.S. Government 
Printing Office, Washington, DC 20402.

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 continues to read, 
in part, as follows:

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

    Par. 2. Section 1.301-2 is added to read as follows:


Sec.  1.301-2  Application to basis.

    (a) Application to basis. That portion of a distribution which is 
not a dividend shall be applied pro rata, on a share-by-share basis, to 
reduce the adjusted basis of each share of stock held by the 
shareholder within the class of stock upon which the distribution is 
made. The following example illustrates this paragraph (a):

    Example. (i) Facts. Corporation X, a calendar year taxpayer, has 
only common stock outstanding. A, an individual, owns all 100 
shares; 25 were acquired on Date 1 for $25 (Block 1) and 75 were 
acquired on Date

[[Page 3514]]

2 for $175 (Block 2). On December 31, when Corporation X had 
earnings and profits of $100, it made a $3 distribution on each 
share of common stock.
    (ii) Analysis. A is treated as receiving $75 of the distribution 
on block 1 and $225 on block 2. On Block 1, A will have a $25 
dividend under section 301(c)(1), a $25 return of capital under 
section 301(c)(2) and a $25 gain under section 301(c)(3). On Block 
2, A will have a $75 dividend under section 301(c)(1), a $150 return 
of capital under section 301(c)(2) and will have a remaining basis 
of $25 in the shares of block 2.

    (b) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.


Sec.  1.302-2  [Amended]

    Par. 3. In Sec.  1.302-2, paragraph (c) is removed and reserved.
    Par. 4. Section 1.302-5 is added to read as follows:


Sec.  1.302-5  Redemptions under section 302(d).

    (a) In general--(1) Share-by-share basis reduction. In any case in 
which an amount received in redemption of stock (as defined in section 
317(b)) is treated as a distribution to which section 301 applies, that 
portion of a distribution that is not a dividend shall be applied to 
reduce the adjusted basis of each share held by the redeemed 
shareholder (as defined in paragraph (b) of this section) in the 
redeemed class (as defined in paragraph (b) of this section). Such 
reduction shall be applied pro rata, on a share-by-share basis, to all 
shares of the redeemed class held by the redeemed shareholder. Gain, if 
any, on a share shall be determined under section 301(c)(3).
    (2) Deemed recapitalization. Except as provided in paragraph (a)(3) 
of this section, immediately following the reduction of basis as 
provided in section 301(c)(2) and paragraph (a)(1) of this section, all 
shares of the redeemed class, including the redeemed shares, held by 
the redeemed shareholder will be treated as surrendered in a 
reorganization described in section 368(a)(1)(E) in exchange for the 
number of shares of the redeemed class directly held by the redeemed 
shareholder after the redemption. The basis of the shares deemed 
received in the reorganization described in section 368(a)(1)(E) will 
be determined under the rules of section 358 and Sec.  1.358-2.
    (3) Redemption of all shares of redeemed class--(i) Remaining basis 
treated as loss. If all the shares of the redeemed class held by the 
redeemed shareholder are redeemed, an amount equal to the basis of the 
redeemed stock, after adjusting such basis to reflect the application 
of section 301(c)(2) as provided in paragraph (a)(1) of this section, 
will be treated as a loss on a disposition of the redeemed stock on the 
date of the redemption. Such loss is taken into account on the 
inclusion date as defined in paragraph (b) of this section.
    (ii) Attributes of loss. Notwithstanding that a loss described in 
paragraph (a)(3)(i) of this section may be deferred and taken into 
account on a date later than the date of the redemption, the attributes 
(for example, character and source) of such loss are determined on the 
date of the redemption that gave rise to such loss.
    (b) Definitions--(1) Redeemed shareholder. Except as provided in 
paragraph (c) of this section, the term redeemed shareholder means the 
person whose stock is redeemed in a transaction. If the redeemed 
shareholder is a corporation, and the assets of the redeemed 
shareholder are acquired in a transaction described in section 381(a) 
(other than transactions described in paragraph (b)(4)(ii) of this 
section), the acquiring corporation (within the meaning of section 381) 
thereafter is treated as the redeemed shareholder.
    (2) Redeemed class. With respect to a shareholder whose stock has 
been redeemed, the term redeemed class means all of the shares of that 
class held by the redeemed shareholder. For this purpose, a class is 
defined with respect to economic rights to distributions rather than 
the labels attached to shares or rights with respect to corporate 
governance.
    (3) Redeeming corporation. The term redeeming corporation means the 
corporation that issued the stock that is redeemed.
    (4) Inclusion date--(i) Definition. The term inclusion date means 
the earlier of--
    (A) 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; or
    (B) The first date on which all classes of stock of the redeeming 
corporation become worthless within the meaning of section 165(g). 
Solely for purposes of this paragraph, if the assets of the redeeming 
corporation (or its successor) are acquired by another corporation in a 
transaction described in section 381(a), the inclusion date for the 
redeemed shareholder is determined by treating all of the facts and 
circumstances that exist at the end of the day that includes the 
section 381 transaction (including the acquisition of the assets of the 
redeeming corporation or its successor) as existing immediately after 
the redemption. A successor for this purpose means a corporation that 
acquires the assets of the redeeming corporation in a transaction to 
which section 381(a) applies.
    (ii) Special rules for corporate shareholders. If the redeemed 
shareholder is a corporation, the inclusion date includes the date such 
corporation has disposed of all of its assets in a transaction in which 
all gain and loss with respect to its assets is recognized in whole, 
and the corporation ceases to exist for tax purposes. If the redeemed 
shareholder is a foreign corporation, the 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 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.
    (c) Rules for special shareholders--(1) Redeemed shareholder is a 
partnership. [Reserved]
    (2) Redeemed shareholder is an S corporation. [Reserved]
    (3) Redeemed shareholder is an estate or trust. [Reserved]
    (d) Operating rules for treatment of loss attributable to basis of 
redeemed stock--
    (1) Treatment as a deferred loss. Any loss attributable to the 
basis of redeemed stock under paragraph (a) of this section that has 
not been permitted to be taken into account under such section shall be 
treated as a deferred loss. The character of the deferred loss as 
ordinary or capital is determined at the time of the redemption.
    (2) Effect of loss attributable to basis of redeemed stock on 
earnings and profits. If the redeemed shareholder is a corporation, any 
deferred loss attributable to the basis of redeemed stock is not 
reflected in such corporation's earnings and profits before it is taken 
into account pursuant to the rules of paragraph (a)(3) of this section. 
See, for example, Sec. Sec.  1.312-6(a) and 1.312-7.
    (e) Examples. For the purposes of the examples in this section, 
Corporations X, Y and Z are domestic corporations

[[Page 3515]]

that file U.S. tax returns on a calendar-year basis. The examples are 
as follows:

    Example 1. (i) Facts. A and B, husband and wife, each own 100 
shares (50 percent) of the common stock of Corporation X which they 
hold as a capital asset. On Date 1, A acquired 50 shares for $100 
(block 1) and 50 shares on Date 2 for $200 (block 2). On December 
31, Corporation X, which has no current or accumulated earnings and 
profits, redeems all of A's block 2 shares for $300. Under section 
302(d), the redemption proceeds are treated under section 301 as a 
recovery of basis.
    (ii) Analysis. Under this section, immediately before the 
redemption, the distribution of property is applied on a pro rata, 
share-by-share basis with respect to each of the shares in the 
redeemed class held directly by A, the redeemed shareholder. 
Accordingly, A will have a $50 capital gain on block 1 ($150-100) 
under section 301(c)(3) and $50 of basis remaining on block 2 ($150-
200). To reflect the actual number of shares held by A after the 
redemption, A's shares in the redeemed class, including the shares 
actually surrendered, will be treated as exchanged in a 
recapitalization under section 368(a)(1)(E). The basis in A's 
recapitalized shares will be determined under Sec.  1.358-2. 
Accordingly, A will have 25 shares with a zero basis (attributable 
to block 1) and 25 shares with a basis of $50 (attributable to block 
2).
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that, Corporation X, on the following December 31, when it 
has no current or accumulated earnings and profits, redeems all of 
A's remaining 50 shares for $40. A does not file an agreement 
described in section 302(c)(2)(A)(iii) waiving family attribution 
under section 318.
    (ii) Analysis. Since A is treated under section 318(a)(1) as 
owning B's shares, the redemption is described in section 302(d) and 
is treated as a distribution to which section 301 applies. As in 
Example 1, immediately before the redemption, the distribution is 
applied on a pro rata, share-by-share basis with respect to each of 
the shares in the redeemed class held by A. Accordingly, A 
recognizes a $20 gain and a $30 loss. The $30 deferred loss under 
Sec.  1.302-5(a)(3) may be taken into account by A on the inclusion 
date (see Sec.  1.302-5(a)(3)(ii)).
    Example 3. (i) Facts. Corporation X has both common and 
preferred stock outstanding. A, an individual, has 100 shares of 
common stock with a basis of $100 and 100 shares of preferred stock 
with a basis of $200. The 100 shares of common stock represent 
voting control of Corporation X. Corporation X, when it has no 
current or accumulated earnings and profits, redeems all of A's 
preferred stock for $150. Section 302(d) applies to the redemption, 
and therefore the distribution is treated as a distribution of 
property to which section 301 applies.
    (ii) Analysis. If Corporation X had declared a distribution 
under section 301 with respect to the redeemed preferred stock, the 
distribution would have been limited to the shares of common stock. 
Therefore, the only basis recovered under section 301(c)(2) is the 
basis of A's preferred stock. A has $50 in excess basis after the 
redemption of all its preferred stock which will not shift to the 
common stock held by A. Under Sec.  1.302-5(a)(3), the excess basis 
will be treated as a deferred loss until the inclusion date.
    Example 4. (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. In 
Year 1, Corporation Z redeems all of A's shares of Corporation Z 
stock for $200. A does not file an agreement described in section 
302(c)(2)(A)(iii) waiving family attribution under section 318. At 
the end of Year 1, Corporation Z has current and accumulated 
earnings and profits in excess of $200. Section 302(d) applies to 
the redemption, and therefore the distribution is treated as a 
distribution to which section 301 applies. A recognizes dividend 
income of $200. In Year 6, Corporation Y, a publicly traded 
corporation 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, B surrenders his shares of 
Corporation Z stock which, at the time of the reorganization have an 
aggregate fair market value of $200, and receives in exchange 5,000 
shares of common stock of Corporation Y representing less than one 
percent of the fair market value of all the stock of Y.
    (ii) Analysis. Under this section, an amount equal to A's basis 
in the redeemed stock after the Year 1 redemption, $50, is treated 
as a deferred loss on a disposition of the redeemed stock on the 
date of the redemption. Under paragraph (b)(3) of this section, 
solely for purposes of determining whether a particular date on or 
after the date of the reorganization is the 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 inclusion date and A is permitted to take into 
account the deferred loss of $50 attributable to his basis in the 
redeemed stock in Year 6.

    (f) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 5. 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/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 6. Section 1.304-2 is amended by revising paragraphs (a) and 
(c), and adding paragraph (d) to read as follows:


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

    (a) In general (1) If a corporation (the acquiring corporation), in 
return for property, acquires the stock of another corporation (the 
issuing corporation) from one or more persons, and such 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 the common 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 the amount constituting a dividend in such cases, 
see Sec.  1.304-6.
    (2) Section 302(b). In applying section 302(b), reference shall be 
made to the ownership of stock in the issuing corporation and not to 
the ownership of the acquiring corporation (except for the purposes of 
applying section 318(a)). Section 318(a) shall be applied without 
regard to the 50 percent limitation contained in section 318(a)(2)(C) 
and (3)(C).
    (3) Section 302(d). If, pursuant to section 302(d), section 301 
applies to the property received in redemption of the common 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 the common stock of the acquiring 
corporation in a transaction to which section 351 applies, and then the 
acquiring corporation had redeemed the common stock it was treated as 
issuing in an exchange for property. Accordingly, the acquiring 
corporation's basis in the stock of the issuing corporation is 
determined under section 362, and, under section 358, the transferor's 
basis in the common stock of the acquiring corporation deemed issued to 
the transferor in the deemed section 351 transaction is equal to the 
transferors basis in the stock of the issuing corporation it 
surrendered.
    (4) Basis of redeemed shares. To the extent that section 301(c)(2) 
applies to the redemption of the common stock of the acquiring 
corporation issued in the deemed section 351 exchange, the amount 
distributed in such redemption

[[Page 3516]]

shall be applied to reduce the adjusted basis of each share of common 
stock directly held or deemed held by the transferor on a pro rata, 
share-by-share basis. See Sec.  1.302-5(a).
    (5) Sale or exchange treatment. If section 301 does not apply to 
the property treated as received in redemption of the common 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 such common stock of the 
acquiring corporation under section 302(a). The basis and the holding 
period of the common stock of the acquiring corporation that is treated 
as redeemed will 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 under section 1012.
* * * * *
    (c) Examples. For purposes of the examples in this section, each of 
corporation is a domestic corporation that files a U.S. tax return on a 
calendar-year basis and in each instance the fair market value of the 
issuing corporation stock is in excess of its adjusted basis. The 
principles of this section are illustrated by the following examples:

    Example 1. (i) Facts. Corporation X and Corporation Y each has 
100 shares of common stock outstanding. 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, to Corporation Y 
for $50.
    (ii) Analysis. Section 304(a)(1) applies to A's sale of 30 
shares of Corporation X stock to Corporation Y because A controls 
both Corporation X and Corporation Y within the meaning of section 
304(c), and Corporation Y acquires the 30 shares of Corporation X 
stock from A in exchange for property ($50 of cash). Pursuant to 
section 304(a)(1), the cash received by A is treated as a redemption 
of the stock of Corporation Y. 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, recognizes a gain of $40 ($50 minus $10). If the stock 
surrendered is a capital asset, such gain is long-term or short-term 
capital gain depending on the period of time that A held such stock. 
A's basis in 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.
    Example 2. (i) Facts. Corporation X and Corporation Y each has 
200 shares of common stock outstanding, all of which are owned by H, 
an individual. H has a basis $100 in his Corporation X stock and $30 
in his Corporation Y stock. Corporation X has $40 and Corporation Y 
has $20 of current and accumulated earnings and profits. H sells his 
200 shares of Corporation X stock to Corporation Y for $150 at a 
time when Corporation Y stock also has a fair market value of $150.
    (ii) Analysis. Section 304(a)(1) applies to H's sale of his 200 
shares of Corporation X stock to Corporation Y because H controls 
both Corporation X and Corporation Y within the meaning of section 
304(c), and Corporation Y acquires the 200 shares of Corporation X 
stock from H in exchange for property. Pursuant to section 
304(a)(1), the cash received by H is treated as a redemption of the 
stock of Corporation Y. Because before the sale H directly owns 100 
percent of Corporation X and after the sale H is treated as owning 
100 percent of Corporation X, section 302(a) does not apply to the 
deemed redemption distribution. Under section 302(d), 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 
common stock in a transaction to which section 351(a) applies. 
Corporation Y's basis in the Corporation X stock acquired is $100 
under section 362(a), the same basis that H had in the Corporation X 
stock surrendered. H takes a basis of $100 in the Corporation Y 
common stock H is treated as receiving in the deemed section 351 
exchange. Corporation Y is then treated as redeeming such 
Corporation Y common stock from H for $150 in a transaction to which 
section 301 applies. H is treated as receiving a dividend of $60 
($20 from the current and accumulated earnings and profits of 
Corporation Y and then $40 from the current and accumulated earnings 
and profits of Corporation X) (see section 304(b)). Under Sec.  
1.302-5, the remaining $90 of the distribution will be applied to 
and reduce the basis of each share of Corporation Y stock held by H. 
Accordingly, H will have no gain on the shares deemed received in 
the section 351 exchange which have a $100 basis, but will have a 
$15 gain on the Corporation Y shares with a $30 basis. After the 
redemption transaction, all of H's shares in Corporation Y, 
including the deemed shares that are redeemed, are treated as 
exchanged in a recapitalization described in section 368(a)(1)(E). 
The basis of the redeemed shares and the shares actually outstanding 
in Corporation Y are allocated pursuant to Sec.  1.358-2(a). 
Accordingly, of H's 200 shares in Corporation Y common stock, 100 
will have a basis of $55, and 100 will have a zero basis.
    Example 3. (i) Facts. Corporation W acquired all of the 
outstanding stock of Corporation X stock for $75 (100 shares of 
common) and then acquired all of the outstanding stock of 
Corporation Y (50 shares of common stock for $75 and 50 shares of 
common stock for $100). Only corporation Y has current or 
accumulated earnings and profits ($100). Corporation W sells all the 
shares in Corporation X to Corporation Y for $300. At the time of 
the transaction, the Corporation X and Corporation Y stock have the 
same fair market value.
    (ii) Analysis. Section 304(a)(1) applies to Corporation W's sale 
of Corporation X to Corporation Y because Corporation W is in 
control of both Corporation X and Corporation Y within the meaning 
of section 304(c), and Corporation Y acquires the Corporation X 
stock in exchange for property. Because before the sale Corporation 
W owns 100 percent of Corporation X, and after the sale is treated 
as owning 100 percent of Corporation X, section 302(a) does not 
apply to the deemed redemption distribution. Under section 302(d), 
the proceeds of the deemed redemption are treated as a distribution 
to which section 301 applies. Section 1059(e)(1)(A)(iii) also 
applies. Corporation W is treated as transferring the Corporation X 
stock to Corporation Y in exchange for Corporation Y common stock in 
a transaction to which section 351(a) applies. Corporation Y's basis 
in the Corporation X stock is $75 under section 362(a), the same 
basis that Corporation W had in the stock it surrendered. 
Corporation W takes a $75 basis in the Corporation Y common stock it 
is deemed to receive in the deemed section 351 transaction. 
Corporation Y is then treated as redeeming such Corporation Y common 
stock from Corporation W for $300. In a redemption to which section 
301 applies, Corporation W is treated as receiving a dividend of 
$100 (from the current and accumulated earnings and profits of 
Corporation Y) (see section 304(b)). Under section 1059, the $100 
dividend is treated as an extraordinary dividend which, under the 
flush language of section 1059(e)(1)(A)(iii), reduces only the basis 
of the stock deemed redeemed, which has a basis of $75. Accordingly, 
Corporation W recognizes a $25 gain. Under Sec.  1.302-5, the 
remaining $200 of the distribution is applied to reduce the basis of 
the Corporation Y stock held by Corporation W on a pro rata, share-
by-share basis, including the basis in the shares deemed redeemed. 
Accordingly, $100 is allocated to the Corporation Y stock that 
Corporation W deemed received in the section 351 transaction that 
now has a zero basis after the application of section 1059 and the 
remaining $100 is allocated to Corporation W's other two blocks of 
Corporation Y stock. Corporation W has a total gain of $125 on the 
Corporation Y stock deemed received and redeemed; and $25 and $50, 
respectively, of remaining basis in the other 2 blocks of 
corporation Y shares. After the redemption transaction, all of 
Corporation W's shares in corporation Y, including the deemed shares 
that are redeemed, are treated as exchanged in a recapitalization 
described in section 368(a)(1)(E). As a result, corporation W will 
have 100 shares in corporation Y, 50 shares will have a zero basis, 
25 shares will have a $25 basis, and 25 shares will have a $50 
basis.

    (d) Effective/applicability date. This section applies to 
transactions that

[[Page 3517]]

occur after the date these regulations are published as final 
regulations in the Federal Register.
    Par. 7. Section 1.304-3 is amended by revising paragraph (a) and 
adding paragraph (c) to 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 will be treated as if the 
parent corporation had redeemed its own stock in exchange for the 
property. For the 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 received in payment in exchange for the stock will be 
made by applying section 302(b) with reference to the stock of the 
issuing parent corporation, or by applying section 303.
* * * * *
    (c) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 8. Section 1.304-5 is amended by adding a sentence at the end 
of paragraph (a) and revising paragraph (c) to read as follows:


Sec.  1.304-5  Control.

    (a) * * * Specifically, section 318(a) will be applied by 
substituting ``5 percent'' for ``50 percent'' in section 318(a)(2)(C) 
and by substituting ``5 percent'' for ``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 corporation bears to 
the value of all stock in such corporation.
* * * * *
    (c) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 9. Section 1.351-2 is amended by redesignating paragraphs (b), 
(c), (d) and (e) as paragraphs (c), (d), (e) and (f), respectively and 
adding new paragraphs (b) and (g) to read as follows:


Sec.  1.351-2  Receipt of property.

* * * * *
    (b) To determine the amount of gain recognized under section 
351(b), the fair market value of each category of consideration 
received by each transferor is allocated to the properties transferred 
in proportion to each property's relative fair market value. The 
application of this paragraph (b) is illustrated by the following 
example:

    Example. C transfers $2,000 in exchange for 200 shares of stock. 
D transfers Asset I, Asset II, and Asset III in exchange for $100 
cash and 100 shares of stock. The exchange is subject to section 
351. At the time of the exchange, Asset I has a fair market value of 
$220 and a basis of $400, Asset II has a fair market value of $330 
and a basis of $200, and Asset III has a fair market value of $550 
and a basis of $250. No gain or loss is recognized to C. Gain, but 
not loss, is recognized by D. To determine the gain recognized by D 
under section 351(b), the fair market value of each category of 
consideration received is allocated to the properties transferred in 
proportion to the relative fair market values of the properties 
transferred. Asset I represents 20 percent of the total fair market 
value of assets transferred (220/1100), Asset II represents 30 
percent (330/1100), and Asset III represents 50 percent (550/1100). 
Under paragraph (b) of this section, the amount of gain recognized 
by D is determined by allocating a pro rata portion of each class of 
consideration received to each property transferred as follows: (A) 
$20 cash and 20 shares of stock to Asset I (20 percent of 100 shares 
of stock and 20 percent of $100 (B) $30 cash and 30 shares of stock 
to Asset II (30 percent of 100 shares of stock and 30 percent of 
$100); and (C) $50 cash and 50 shares of stock to Asset III (50 
percent of 100 shares of stock and 50 percent of $100). D realizes a 
loss of $180 on Asset I, none of which is recognized, a gain of $130 
on Asset II, $30 of which is recognized, and a gain of $300 on Asset 
III, $50 of which is recognized.
* * * * *
    (g) This section applies to exchanges that occur after the date 
these regulations are published as final regulations in the Federal 
Register, except for exchanges which occur pursuant to a written 
agreement that is binding on or before the date these regulations are 
published as final in the Federal Register. For exchanges that occur on 
or before the date that these regulations are published as final 
regulations in the Federal Register, see this section as contained in 
26 CFR part 1 revised April 1, for the year before these regulations 
are published as final regulations in the Federal Register.
    Par. 10. Section 1.354-1 is amended by:
    1. Revising the section heading.
    2. Redesignating paragraphs (d), (e) and (f) as paragraphs (e), (f) 
and (g), respectively.
    3. Adding new paragraphs (d) and (h).
    4. Adding Example 5 to the end of newly designated paragraph (e).
    The additions and revisions read as follows:


Sec.  1.354-1  Exchanges of stock, securities and other property in 
certain reorganizations.

* * * * *
    (d) Exchanges solely or partly for money or other property--(1) 
Determination of consideration for a share of stock or a security. In 
determining the consideration received for a share of stock or a 
security, except as otherwise provided in this paragraph (d)(1), a pro 
rata portion of any other property and money received shall be treated 
as received in exchange for each share of stock and security 
surrendered, based on the fair market value of such surrendered share 
of stock or security. However, to the extent the terms of the exchange 
specify the other property or money that is received in exchange for a 
particular share of stock or security surrendered or a particular class 
of stock or securities surrendered, such terms shall control provided 
that the terms are economically reasonable, unless the shareholder's 
exchange has the effect of a distribution of a dividend. If the 
exchange has the effect of a distribution of a dividend and the terms 
of an exchange specify the other property or money that is received 
with respect to a particular share of stock and such specification 
would otherwise be economically reasonable, such other property or 
money shall be treated as received pro rata in exchange for each share 
of stock within that class (as defined in section 1.302-5(b)(2)) held 
by the exchanging shareholder. Notwithstanding the preceding sentence, 
economically reasonable designations between classes of stock or 
securities (as opposed to within a class) shall generally control. All 
exchanges made by an exchanging shareholder, whether governed by 
section 354, 356, or 302, are taken into account to determine whether 
the shareholder's exchange has the effect of a distribution of a 
dividend.
    (2) Treatment of exchanges of stock solely for money or other 
property. Neither section 354 nor so much of section 356 as relates to 
section 354 applies to a shareholder's surrender of a share of stock in 
exchange solely for money or other property that is not permitted to be 
received without the recognition of gain, even though such exchange is 
pursuant to a plan of reorganization described in section 368(a), and 
even though section 354, section 356 or both sections 354 and 356 apply 
to the exchange of other shares by that shareholder or other 
shareholders. See section 302 and the regulations

[[Page 3518]]

under that section for the treatment of such an exchange.
    (e) * * *

    Example 5. D owns shares of Class A common stock, Series 1 
preferred stock, and Series 2 preferred stock in Corporation T. The 
Series 1 preferred stock and the Series 2 preferred stock are 
different classes of stock. Pursuant to a reorganization described 
in section 368(a) to which corporations T and V are parties, D 
surrenders all of D's Class A common stock in Corporation T in 
exchange for common stock in Corporation V, all of D's Series 1 
preferred stock in Corporation T in exchange for both cash and 
common stock in Corporation V, and all of D's Series 2 preferred 
stock in Corporation T in exchange solely for cash. Section 354 
applies to the exchange of the Class A common stock in Corporation T 
for Corporation V common stock. Section 356 applies to the exchange 
of Series 1 preferred stock for Corporation V common stock and cash. 
Neither section 354 (nor so much of section 356 as relates to 
section 354) applies to the exchange of Series 2 preferred stock in 
Corporation T solely for cash (see section 302 and regulations 
thereunder).
* * * * *
    (h) This section applies to exchanges that occur after the date 
these regulations are published as final regulations in the Federal 
Register, except for exchanges which occur pursuant to a written 
agreement that is binding on or before the date these regulations are 
published as final in the Federal Register. For exchanges that occur on 
or before the date these regulations are published as final regulations 
in the Federal Register, see this section as contained in 26 CFR part 1 
revised April 1, for the year before these regulations are published as 
final regulations in the Federal Register.
    Par. 11. Section 1.355-1 is amended by adding new paragraph (e) to 
read as follows:


Sec.  1.355-1  Distribution of stock and securities of a controlled 
corporation.

* * * * *
    (e) Exchanges solely or partly for money and other property--(1) 
Determination of consideration for a share of stock or a security. In 
determining the consideration received for a share of stock or a 
security, except as otherwise provided in this paragraph (e)(1), a pro 
rata portion of any other property and money received shall be treated 
as received in exchange for each share of stock and security 
surrendered, based on the fair market value of such surrendered share 
of stock or security. However, to the extent the terms of the exchange 
specify the other property or money that is received in exchange for a 
particular share of stock or security surrendered or a particular class 
of stock or securities surrendered, such terms shall control provided 
that the terms are economically reasonable, unless the shareholder's 
exchange has the effect of a distribution of a dividend. If the 
exchange has the effect of a distribution of a dividend and the terms 
of an exchange specify the other property or money that is received 
with respect to a particular share of stock and such specification 
would otherwise be economically reasonable, such other property or 
money shall be treated as received pro rata in exchange for each share 
of stock within that class (as defined in Sec.  1.302-5(b)(2)) held by 
the exchanging shareholder. Notwithstanding the preceding sentence, 
economically reasonable designations among classes of stock (as opposed 
to within a class) shall generally control. All exchanges made by an 
exchanging shareholder, whether governed by section 355, 356, or 302, 
are taken into account to determine whether the shareholder's exchange 
has the effect of a distribution of a dividend.
    (2) Treatment of exchanges of stock solely for money or other 
property. Neither section 355 nor so much of section 356 as relates to 
section 355 applies to a shareholder's surrender of a share of stock in 
exchange solely for money or other property that is not permitted to be 
received without the recognition of gain, even though such exchange is 
pursuant to a plan of reorganization described in section 368(a), or 
even though section 355, section 356 or both sections 355 and 356 apply 
to the exchange of other shares by that shareholder or other 
shareholders. See section 302 and the regulations under that section 
for the treatment of such an exchange. Any such exchange is treated as 
occurring immediately before any distribution of or exchange for the 
stock of the controlled corporation to which section 355 (or so much of 
section 356 as relates to section 355) applies.
    (3) Effective/applicability date. This paragraph (e) applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register, except for exchanges 
which occur pursuant to a written agreement that is binding on or 
before the date these regulations are published as final in the Federal 
Register.
    Par. 12. Section 1.356-1 is amended by revising paragraph (b), 
Examples 3 and 4 to paragraph (d), and paragraph (g) to read as 
follows:


Sec.  1.356-1  Receipt of additional consideration in connection with 
an exchange.

* * * * *
    (b) The rules of Sec.  1.354-1(d)(1) or Sec.  1.355-1(e)(1), as the 
case may be, apply for purposes of computing the gain, if any, 
recognized pursuant to section 356(a) and paragraph (a)(1) of this 
section.
* * * * *
    (d) * * *

    Example 3. (i) Facts. J, an individual, acquired 10 shares of 
stock of Corporation X on Date 1 for $3 each (Block 1) and 10 shares 
of stock of Corporation X on Date 2 for $9 each (Block 2). On Date 
3, Corporation Y acquires the assets of Corporation X in a 
reorganization under section 368(a)(1)(A). Pursuant to the terms of 
the plan of reorganization, J surrenders all of J's shares of 
Corporation X stock for 10 shares of Corporation Y stock and $100 of 
cash. On the date of the exchange, the fair market value of each 
share of stock of Corporation X is $10 and the fair market value of 
each share of Corporation Y stock is $10. The terms of the exchange 
do not specify that shares of Corporation Y stock or cash are 
received in exchange for particular shares of stock of Corporation 
X. In addition, the distribution of the $100 of cash does not have 
the effect of a distribution of a dividend.
    (ii) Analysis. Under paragraph (b) of this section, because the 
terms of the exchange do not specify that the cash is received in 
exchange for particular shares of stock of Corporation X, a pro rata 
portion of the cash received is treated as received in exchange for 
each share of stock of Corporation X based on the fair market value 
of the surrendered shares. Therefore, J is treated as receiving 
shares of Corporation Y stock with a fair market value of $100 and 
$100 of cash in exchange for each block of J's stock of Corporation 
X. J realizes a gain of $70 on the exchange of the Block 1 shares of 
Corporation X stock, $50 of which is recognized under section 356 
and paragraph (a) of this section, and J realizes a gain of $10 on 
the exchange of the Block 2 shares of Corporation X stock, all of 
which is recognized under section 356 and paragraph (a) of this 
section. Because J's gain recognized is not treated as a dividend 
under section 356(a)(2), such gain shall be treated as gain from the 
exchange of property.
    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that the terms of the plan of reorganization specify that J 
receives 10 shares of stock of Corporation Y in exchange for J's 
Block 1 shares of stock of Corporation X and $100 of cash in 
exchange for J's Block 2 shares of stock of corporation X.
    (ii) Analysis. Under paragraph (b) of this section, because the 
terms of the exchange specify that J receives 10 shares of stock of 
Corporation Y in exchange for J's Block 1 shares of stock of 
Corporation X and $100 of cash in exchange for J's Block 2 shares of 
stock of Corporation X and such terms are economically reasonable, 
such terms control. J realizes a gain of $70 on the exchange of the 
Block 1 shares of stock, none of which is recognized under section 
354. J realizes a gain of $10 on the exchange of the Block 2 shares 
of stock of Corporation X, all of which is recognized under section 
302(a).
* * * * *

[[Page 3519]]

    (g) This section applies to exchanges and distributions that occur 
after the date these regulations are published as final regulations in 
the Federal Register, except for exchanges which occur pursuant to a 
written agreement that is binding on or before the date these 
regulations are published as final in the Federal Register. For 
exchanges and distributions that occur on or before the date these 
regulations are published as final regulations in the Federal Register, 
see this section as contained in 26 CFR part 1 revised April 1, for the 
year before these regulations are published as final regulations in the 
Federal Register.
    Par. 13. Section 1.358-1 is revised to read as follows:


Sec.  1.358-1  Basis to distributees.

    (a) Certain exchanges or distributions in which only nonrecognition 
property is received--(1) Exchanges to which section 354 or 355 
applies. In the case of an exchange to which section 354 or 355 applies 
in which only nonrecognition property is received, the sum of the basis 
of all of the stock and securities received in the transaction shall be 
the same as the basis of all of the stock and securities in such 
corporation surrendered in the transaction, allocated in the manner 
described in Sec.  1.358-2.
    (2) Distributions to which section 355 applies. In the case of a 
distribution to which section 355 applies in which only nonrecognition 
property is received, the sum of the basis of all of the stock and 
securities with respect to which the distribution is made plus the 
basis of all of the stock and securities received in the distribution 
with respect to such stock and securities shall be the same as the 
basis of the stock and securities with respect to which the 
distribution is made immediately before the transaction, allocated in 
the manner described in Sec.  1.358-2.
    (3) Exchanges to which section 351 or 361 applies. In the case of 
an exchange to which section 351 or 361 applies in which only 
nonrecognition property is received, the basis of all of the stock and 
securities received in the exchange shall be the same as the basis of 
all of the property exchanged for such stock and securities.
    (b) Certain exchanges or distributions in which both nonrecognition 
property and ``other property'' or money are received--(1) Exchanges or 
distributions to which section 351, 356, or 361 applies. If in an 
exchange or distribution to which section 351, 356, or 361 applies both 
nonrecognition property and ``other property'' or money are received, 
the basis of the nonrecognition property held after the transaction 
shall be determined as described in paragraph (a) of this section, 
decreased by the sum of the money and the fair market value of the 
``other property'' (as of the date of the transaction) received and 
increased by the sum of the amount treated as a dividend (if any) and 
the amount of the gain recognized on the exchange (other than gain 
treated as a dividend).
    (2) Cases in which loss is recognized. In any case in which a 
taxpayer transfers property with respect to which loss is recognized, 
such loss shall be reflected in determining the basis of the property 
received in the exchange.
    (3) Basis of ``other property'' received. The basis of the ``other 
property'' is its fair market value as of the date of the transaction.
    (c) Other rules. See Sec.  1.460-4(k)(3)(iv)(A) for rules relating 
to stock basis adjustments required where a contract accounted for 
using a long-term contract method of accounting is transferred in a 
transaction described in section 351 or a reorganization described in 
section 368(a)(1)(D) with respect to which the requirements of section 
355 (or so much of section 356 as relates to section 355) are met.
    (d) The application of this section may be illustrated by the 
following example:

    Example. A purchased a share of stock in Corporation X on Date 1 
for $150. Since that date, A has received distributions under 
section 301(c)(2) totaling $60, so that A's adjusted basis for the 
stock is $90. In a transaction qualifying under section 356, A 
exchanged this share for one share in Corporation Y, with a value of 
$100, cash of $10, and other property with a fair market value of 
$30. The exchange had the effect of the distribution of a dividend. 
A's ratable share of the earnings and profits of Corporation X was 
$5. A realized a gain of $50 on the exchange ($140 - $90), but the 
amount of gain recognized is limited to $40, the sum of the cash 
received and the fair market value of the other property. Of the 
gain recognized, $5 is taxable as a dividend, and $35 is taxable as 
a gain from the exchange of property. The basis to A of the one 
share of stock of Corporation Y is $90, that is the adjusted basis 
of the one share of stock of Corporation X ($90), decreased by the 
sum of the cash received ($10) and the fair market value of the 
other property received ($30) and increased by the sum of the amount 
treated as a dividend ($5) and the amount treated as a gain from the 
exchange of property ($35). The basis of the other property received 
is $30.

    (e) Effective/applicability date. This section applies to exchanges 
and distributions of stock and securities that occur after the date 
these regulations are published as final regulations in the Federal 
Register, except for exchanges which occur pursuant to a written 
agreement that is binding on or before the date these regulations are 
published as final in the Federal Register. For exchanges and 
distributions that occur on or before the date these regulations are 
published as final regulations in the Federal Register, see this 
section as contained in 26 CFR part 1 revised April 1, for the year 
before these regulations are published as final regulations in the 
Federal Register.
    Par. 14. Section 1.358-2 is revised to read as follows:


Sec.  1.358-2  Allocation of basis among nonrecognition property in 
certain exchanges or distributions.

    (a) Introduction--(1) Scope. This section prescribes rules for 
allocating basis in the case of an exchange or distribution to which 
section 354, 355 or 356 applies. For rules that apply to transfers of 
stock and other property where the transfer of stock is described in 
section 351 but does not qualify as a reorganization, see Sec.  1.358-
2(g). For transfers of stock described in section 361, see Sec.  1.358-
2(h).
    (2) Definitions. As used in this section the term stock means stock 
which is not ``other property'' under sections 351, 356, or 361, as 
applicable. The term securities means securities (including, where 
appropriate, fractional parts of securities) which are not ``other 
property'' under sections 356 or 361, as applicable. Stock, or 
securities, as the case may be, which differ either because they are in 
different corporations or because the rights attributable to them 
differ (although they are in the same corporation) are considered 
different classes of stock or securities, as the case may be, for 
purposes of this section.
    (b) Exchanges to which section 354, 355, or 356 applies. If a 
shareholder or security holder surrenders one or more shares of stock 
or one or more securities in an exchange under the terms of section 
354, 355 or 356, the following rules apply:
    (1) In general. Except as otherwise provided in this section, the 
basis of each share of stock or security received in the exchange shall 
be the same as the basis of the share or shares of stock or security or 
securities (or allocable portions thereof) exchanged therefor (as 
adjusted under Sec.  1.358-1).
    (2) More shares of stock or securities received than surrendered. 
If more than one share of stock or security is received in exchange for 
one share of stock or one security, the basis of the share of stock or 
security surrendered shall be allocated to the shares of stock or 
securities received in proportion to the fair market value of the 
shares of stock or securities received.

[[Page 3520]]

    (3) Fewer shares of stock or securities received than surrendered--
(i) In general. If one share of stock or security is received in 
exchange for more than one share of stock or security or if a fraction 
of a share of stock or security is received, then the basis of the 
shares of stock or securities surrendered must be allocated to the 
shares of stock or securities (or allocable portions thereof) received 
in a manner that reflects, to the greatest extent possible, that a 
share of stock or security received is received in respect of shares of 
stock or securities that were acquired on the same date and at the same 
price. To the extent it is not possible to allocate basis in this 
manner, the basis of the shares of stock or securities surrendered must 
be allocated to the shares of stock or securities (or allocable 
portions thereof) received in a manner that minimizes the disparity in 
the holding periods of the surrendered shares of stock or securities 
whose basis is allocated to any particular share of stock or security 
received.
    (ii) Surrendered shares of stock or securities acquired on 
different dates or at different prices. If a share of stock or a 
security is received in exchange for more than one share of stock or 
security and such shares of stock or securities were acquired on 
different dates or at different prices, the share of stock or security 
received shall be divided into segments based on the relative fair 
market values of the shares of stock or securities surrendered in 
exchange for such share or security. Each segment shall have a basis 
determined under the rules of this section and a corresponding holding 
period.
    (4) ``Other property,'' money, or more than one class of stock or 
securities received. If a shareholder or security holder receives 
shares of stock or securities of more than one class, or receives 
``other property'' or money in addition to shares of stock or 
securities, the rules of Sec. Sec.  1.354-1(d)(1) and 1.355-1(e)(1) 
apply for purposes of applying the rules of this section.
    (5) Pro rata exchanges to which section 355 or section 356(b) 
applies. If a shareholder or security holder surrenders stock in 
distributing (as defined in Sec.  1.355-1(b)) for only stock in 
controlled and the receipt of the controlled stock would be treated, 
within the meaning of section 302(d), as a distribution of property to 
which section 301 applies if the controlled stock received were money 
or other property, then the basis of the shares received shall be 
determined under the rules of paragraph (c) of this section and not the 
rules of this paragraph (b). The rules of paragraph (c) and not the 
rules of this paragraph (b) also apply to distributions subject to 
section 356(b).
    (c) Distributions to which section 355 applies. If a shareholder or 
security holder receives one or more shares of stock or one or more 
securities in a distribution under section 355 (or so much of section 
356 as relates to section 355), the following rules apply:
    (1) In general. Except as otherwise provided in this section, the 
basis of each share of stock or security of the distributing 
corporation (as defined in Sec.  1.355-1(b)), as adjusted under Sec.  
1.358-1, shall be allocated between the share of stock or security of 
the distributing corporation with respect to which the distribution is 
made and the share or shares of stock or security or securities (or 
allocable portions thereof) received in proportion to their fair market 
values.
    (2) Fewer shares of stock or securities received than with respect 
to which distributed--(i) In general. If one share of stock or security 
is received with respect to more than one share of stock or security or 
if a fraction of a share of stock or security is received, then the 
basis of each share of stock or security of the distributing 
corporation must be allocated to the shares of stock or securities (or 
allocable portions thereof) received in a manner that reflects that, to 
the greatest extent possible, a share of stock or security received is 
received with respect to shares of stock or securities acquired on the 
same date and at the same price. To the extent it is not possible to 
allocate basis in this manner, the basis of each share of stock or 
security of the distributing corporation must be allocated to the 
shares of stock or securities (or allocable portions thereof) received 
in a manner that minimizes the disparity in the holding periods of the 
shares of stock or securities with respect to which such shares of 
stock or securities are received.
    (ii) Distribution upon shares of stock or securities acquired on 
different dates or at different prices. If a share of stock or a 
security is received with respect to more than one share of stock or 
security and such shares or securities were acquired on different dates 
or at different prices, the share of stock or security received shall 
be divided into segments based on the relative fair market values of 
the shares of stock or securities with respect to which the share of 
stock or security is received. Each segment shall have a basis 
determined under the rules of this section and a corresponding holding 
period.
    (3) ``Other property,'' money, or more than one class of stock or 
securities received. If a shareholder or security holder receives 
shares of stock or securities of more than one class, or receives 
``other property'' or money in addition to stock or securities, the 
rules of Sec.  1.355-1(e)(1) apply for purposes of applying the rules 
of this section as though the distribution were an exchange.
    (d) Reorganizations in which stock is deemed received. For purposes 
of this section, if a shareholder or security holder surrenders a share 
of stock or a security in a transaction under the terms of section 354 
(or so much of section 356 as relates to section 354) in which such 
shareholder or security holder receives no property or receives 
property (including property permitted by section 354 to be received 
without the recognition of gain or ``other property'' or money) with a 
fair market value less than that of the stock or securities surrendered 
in the transaction, such shareholder or security holder shall be 
treated as provided in paragraphs (1) and (2) of this paragraph (d).
    (1) Step one: Deemed issuance. First, the shareholder or security 
holder shall be treated as receiving the stock, securities, other 
property, and money actually received by the shareholder or security 
holder in the transaction and an amount of stock of the issuing 
corporation (as defined in Sec.  1.368-1(b)) that has a value equal to 
the excess of the value of the stock or securities the shareholder or 
security holder surrendered in the transaction over the value of the 
stock, securities, other property, and money the shareholder or 
security holder actually received in the transaction. If the 
shareholder owns only one class of stock of the issuing corporation the 
receipt of which would be consistent with the economic rights 
associated with each class of stock of the issuing corporation, the 
stock deemed received by the shareholder pursuant to the previous 
sentence shall be stock of such class. If the shareholder owns multiple 
classes of stock of the issuing corporation the receipt of which would 
be consistent with the economic rights associated with each class of 
stock of the issuing corporation, the stock deemed received by the 
shareholder shall be stock of each such class owned by the shareholder 
immediately prior to the transaction, in proportion to the value of the 
stock of each such class owned by the shareholder immediately prior to 
the transaction. The basis of each share of stock or security deemed 
received and actually received shall be determined under the rules of 
this section.
    (2) Step two: Deemed section 368(a)(1)(E) exchange. Second, the

[[Page 3521]]

shareholder or security holder shall then be treated as surrendering 
all of its shares of stock and securities in the issuing corporation, 
including those shares of stock or securities held immediately prior to 
the transaction, those shares of stock or securities actually received 
in the transaction, and those shares of stock deemed received pursuant 
to paragraph (d)(1) of this section, in a reorganization under section 
368(a)(1)(E) in exchange for the shares of stock and securities of the 
issuing corporation that the shareholder or security holder actually 
holds immediately after the transaction. The basis of each share of 
stock and security deemed received in the reorganization under section 
368(a)(1)(E) shall be determined under the rules of this section.
    (e) Designating which stock or securities were received for, or 
with respect to, the stock or securities surrendered or distributed 
upon--(1) In general. If a shareholder or security holder that 
purchased or acquired shares of stock or securities in a corporation on 
different dates or at different prices exchanges such shares of stock 
or securities under the terms of section 354, 355, or 356, or receives 
a distribution of shares of stock or securities under the terms of 
section 355 (or so much of section 356 as relates to section 355), and 
the shareholder or security holder is not able to identify which 
particular share of stock or security (or allocable portion of a share 
of stock or security) is received (or deemed received) in exchange for, 
or with respect to, a particular share of stock or security, the 
shareholder or security holder may designate subject to the limitations 
of this section, which share of stock or security is received in 
exchange for, or with respect to, a particular share of stock or 
security, provided that such designation is consistent with the terms 
of the exchange or distribution (or an exchange deemed to have occurred 
pursuant to paragraph (d) of this section), and the other rules of this 
section. The designation will be binding for purposes of determining 
the Federal tax consequences of any sale or transfer of, or 
distribution with respect to, the shares or securities received.
    (2) Timing for designation--(i) In exchanges under section 354 or 
356. In the case of an exchange under the terms of section 354 or 356 
(including a deemed exchange as a result of the application of 
paragraph (d) of this section), the designation must be made on or 
before the first date on which the basis of a share of stock or a 
security received (or deemed received in the reorganization under 
section 368(a)(1)(E) in the case of a transaction to which paragraph 
(d) of this section applies) is relevant. The basis of the shares or 
securities received in an exchange under the terms of section 354 or 
section 356, for example, is relevant when such shares or securities 
are sold or otherwise transferred.
    (ii) In exchanges or distributions under section 355. In the case 
of an exchange or distribution under the terms of section 355 (or so 
much of section 356 as relates to section 355), the designation must be 
made on or before the first date on which the basis of a share of stock 
or a security of the distributing corporation or the controlled 
corporation (as defined in Sec.  1.355-1(b)) is relevant.
    (3) Failure to designate. If the shareholder fails to make a 
designation in a case in which the shareholder is not able to identify 
which share of stock is received in exchange for, or with respect to, a 
particular share of stock, then the shareholder will not be able to 
identify which shares are sold or transferred for purposes of 
determining the basis of property sold or transferred under section 
1012 and Sec.  1.1012-1(c) and, instead, will be treated as selling or 
transferring the share received in respect of the earliest share 
purchased or acquired.
    (f) Applicability of section to certain overlap situations--(1) 
Exchanges described in both section 1036 and section 354 or 356. The 
rules of paragraphs (a) through (e) of this section shall 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 
1036 and section 354 or 356.
    (2) Exchanges described in both section 351 and section 354 or 356. 
The rules of paragraphs (a) through (e) of this section shall 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 section 354 or 356, unless liabilities of the shareholder or 
security holder are assumed in connection with the exchange.
    (g) Section 351 exchanges--(1) In general. Except as provided in 
paragraph (g)(2) of this section, if in an exchange to which section 
351 applies property is transferred to a corporation and the transferor 
receives more than one share of stock, then the aggregate basis of the 
property transferred (as adjusted under Sec.  1.358-1) shall be 
allocated among all of the shares of stock received in proportion to 
the fair market values of each share of stock.
    (2) Stock and property transferred in an exchange without a 
liability assumption. If in an exchange to which section 351 applies 
stock or stock and property is transferred to a corporation and no 
liability is assumed by the transferee in the exchange, then the basis 
of the stock transferred (as adjusted under Sec.  1.358-1) shall be 
allocated pursuant to paragraphs (b)(1) through (b)(3) of this section. 
Such rules also apply to other property, money or more than one class 
of stock or securities received.
    (3) Transactions in which stock is deemed received. For purposes of 
this paragraph (g), if a shareholder transfers property to a 
corporation in a transaction to which section 351 applies, and such 
shareholder receives no property or property (including property 
permitted by section 351 to be received without the recognition of gain 
or ``other property'' or money) in such corporation with a fair market 
value less than that of the property transferred in the transaction, 
such shareholder shall be treated as provided in paragraphs (3)(i) and 
(ii) of this paragraph (g).
    (i) Step one: Deemed issuance. First, the shareholder shall be 
treated as receiving the stock, other property, and money actually 
received by the shareholder in the transaction and an amount of stock 
of the transferee corporation that has a value equal to the excess of 
the value of the property the shareholder transferred in the 
transaction over the value of the stock, other property, and money the 
shareholder actually received in the transaction. If the shareholder 
owns only one class of stock of the transferee corporation the receipt 
of which would be consistent with the economic rights associated with 
each class of stock of the transferee corporation, the stock deemed 
received by the shareholder pursuant to the previous sentence shall be 
stock of such class. If the shareholder owns multiple classes of stock 
of the transferee corporation the receipt of which would be consistent 
with the economic rights associated with each class of stock of the 
transferee corporation, the stock deemed received by the shareholder 
shall be stock of each such class owned by the shareholder immediately 
prior to the transaction, in proportion to the value of the stock of 
each such class owned by the shareholder immediately prior to the 
transaction.
    (ii) Step two: Deemed section 368(a)(1)(E) exchange. Second, the 
shareholder shall then be treated as surrendering all of its shares of 
stock in the transferee corporation, including those shares of stock 
held immediately

[[Page 3522]]

prior to the transaction, those shares of stock actually received in 
the transaction, and those shares of stock deemed received pursuant to 
paragraph (3)(i) of this paragraph (g), in a reorganization under 
section 368(a)(1)(E) in exchange for the shares of stock of the 
transferee corporation that the shareholder actually holds immediately 
after the transaction. The basis of each share of stock deemed received 
in the reorganization under section 368(a)(1)(E) shall be determined 
under the rules of this section.
    (h) Section 361 exchanges. If in an exchange to which section 361 
applies property is transferred to a corporation and the transferor 
receives stock or securities of more than one class or receives both 
stock and securities, then the basis of the property transferred (as 
adjusted under Sec.  1.358-1) shall be allocated among all of the stock 
and securities received in proportion to the fair market values of the 
stock of each class and the securities of each class.
    (i) Examples. The application of this section is illustrated by the 
following examples:

    Example 1. More shares of stock received than surrendered. (i) 
Facts. J, an individual, acquired 20 shares of Corporation X stock 
on Date 1 for $3 each and 10 shares of Corporation X stock on Date 2 
for $6 each. On Date 3, Corporation Y acquires the assets of 
Corporation X in a reorganization under section 368(a)(1)(A). 
Pursuant to the terms of the plan of reorganization, J receives 2 
shares of Corporation Y stock in exchange for each share of 
Corporation X stock. Therefore, J receives 60 shares of Corporation 
Y stock. Pursuant to section 354, J recognizes no gain or loss on 
the exchange. J is not able to identify which shares of Corporation 
Y stock are received in exchange for each share of Corporation X 
stock.
    (ii) Analysis. Under paragraph (b)(2) of this section, J has 40 
shares of Corporation Y stock each of which has a basis of $1.50 and 
is treated as having been acquired on Date 1 and 20 shares of 
Corporation Y stock each of which has a basis of $3 and is treated 
as having been acquired on Date 2. Under paragraph (e) of this 
section, on or before the date on which the basis of a share of 
Corporation Y stock received becomes relevant, J may designate which 
of the shares of corporation Y stock have a basis of $1.50 and which 
have a basis of $3.
    Example 2. More shares of stock received than surrendered. (i) 
Facts. The facts are the same as in Example 1, except that instead 
of receiving 2 shares of Corporation Y stock in exchange for each 
share of Corporation X stock, J receives 1\1/2\ shares of 
Corporation Y stock in exchange for each share of Corporation X 
stock. Therefore, J receives 45 shares of corporation Y stock. 
Again, J is not able to identify which shares (or portions of 
shares) of Corporation Y stock are received in exchange for each 
share of Corporation X stock.
    (ii) Analysis. Under paragraph (b)(2) of this section, J has 30 
shares of Corporation Y stock each of which has a basis of $2 and is 
treated as having been acquired on Date 1 and 15 shares of 
Corporation Y stock each of which has a basis of $4 and is treated 
as having been acquired on Date 2. Under paragraph (e) of this 
section, on or before the date on which the basis of a share of 
Corporation Y stock received becomes relevant, J may designate which 
of the shares of Corporation Y stock received have a basis of $2 and 
which have a basis of $4.
    Example 3. More than one class of stock received. (i) Facts. J, 
an individual, acquired 10 shares of Class A stock of Corporation X 
on Date 1 for $3 each, 10 shares of Class A stock of Corporation X 
on Date 2 for $9 each, and 10 shares of Class B stock of Corporation 
X on Date 3 for $3 each. On Date 4, J surrenders all of J's shares 
of Class A stock in exchange for 20 shares of new Class C stock and 
20 shares of new Class D stock in a reorganization under section 
368(a)(1)(E). Pursuant to section 354, J recognizes no gain or loss 
on the exchange. On the date of the exchange, the fair market value 
of each share of Class A stock is $6, the fair market value of each 
share of Class C stock is $2, and the fair market value of each 
share of Class D stock is $4. The terms of the exchange do not 
specify that shares of Class C stock or shares of Class D stock of 
Corporation X are received in exchange for particular shares of 
Class A stock of Corporation X.
    (ii) Analysis. Under paragraph (b)(4) of this section, because 
the terms of the exchange do not specify that shares of Class C 
stock or shares of Class D stock of Corporation X are received in 
exchange for particular shares of Class A stock of Corporation X, a 
pro rata portion of the shares of Class C stock and shares of Class 
D stock received will be treated as received in exchange for each 
share of Class A stock based on the fair market value of the 
surrendered shares of Class A stock. Therefore, J is treated as 
receiving one share of Class C stock and one share of Class D stock 
in exchange for each share of Class A stock. Under paragraph (b)(2) 
of this section, J has 10 shares of Class C stock, each of which has 
a basis of $1 and is treated as having been acquired on Date 1 and 
10 shares of Class C stock, each of which has a basis of $3 and is 
treated as having been acquired on Date 2. In addition, J has 10 
shares of Class D stock, each of which has a basis of $2 and is 
treated as having been acquired on Date 1 and 10 shares of Class D 
stock, each of which has a basis of $6 and is treated as having been 
acquired on Date 2. J's basis in each share of Class B stock remains 
$3. Under paragraph (e) of this section, on or before the date on 
which the basis of a share of Class C stock or Class D stock 
received becomes relevant, J may designate which of the shares of 
Class C stock have a basis of $1 and which have a basis of $3, and 
which of the shares of Class D stock have a basis of $2 and which 
have a basis of $6.
    Example 4. Money received in addition to stock. (i) Facts. J, an 
individual, acquired 10 shares of stock of Corporation X on Date 1 
for $2 each (Block 1), 10 shares of stock of Corporation X on Date 2 
for $4 each (Block 2), and 20 shares of stock of Corporation X on 
Date 3 for $6 each (Block 3). On Date 4, Corporation Y acquires the 
assets of Corporation X in a reorganization under section 
368(a)(1)(A). Pursuant to the terms of the plan of reorganization, J 
surrenders all of J's shares of Corporation X stock for 40 shares of 
Corporation Y stock and $200 of cash. The distribution of $200 of 
cash does not have the effect of a distribution of a dividend. On 
the date of the exchange, the fair market value of each share of 
stock of Corporation X is $10, and the fair market value of each 
share of Corporation Y stock is $5. The terms of the exchange do not 
specify that shares of Corporation Y stock or cash are received in 
exchange for particular shares of stock of Corporation X.
    (ii) Analysis. Under paragraph (b)(4) of this section and under 
Sec.  1.356-1(b), because the terms of the exchange do not specify 
that shares of Corporation Y stock or cash are received in exchange 
for particular shares of stock of Corporation X, a pro rata portion 
of the shares of Corporation Y stock and cash received will be 
treated as received in exchange for each share of stock of 
Corporation X surrendered based on the fair market value of such 
stock. Therefore, J is treated as receiving one share of Corporation 
Y stock and $5 of cash in exchange for each share of stock of 
Corporation X. J realizes a gain of $80 on the exchange of Block 1, 
$50 of which is recognized under Sec.  1.356-1(a). J realizes a gain 
of $60 of the exchange of Block 2, $50 of which is recognized under 
Sec.  1.356-1(a). J realizes a gain of $80 on the exchange of the 
Block 3 shares of stock of Corporation X, all of which is recognized 
under Sec.  1.356-1(a). Under paragraph (b)(1) of this section, J 
has 10 shares of Corporation Y stock, each of which has a basis of 
$2 and is treated as having been acquired on Date 1, 10 shares of 
Corporation Y stock, each of which has a basis of $4 and is treated 
as having been acquired on Date 2, and 20 shares of Corporation Y 
stock, each of which has a basis of $5 and is treated as having been 
acquired on Date 3. Under paragraph (e) of this section, on or 
before the date on which the basis of a share of Corporation Y stock 
received becomes relevant, J may designate which of the shares of 
Corporation Y stock received have a basis of $2, which have a basis 
of $4, and which have a basis of $5.
    Example 5. Money received in addition to stock. (i) Facts. The 
facts are the same as in Example 4, except that the terms of the 
plan of reorganization specify that J receives 40 shares of stock of 
Corporation Y in exchange for J's Block 1 and Block 2 shares of 
stock of Corporation X and $200 of cash in exchange for J's Block 3 
shares of stock of Corporation X.
    (ii) Analysis. Under paragraph (b)(4) of this section and under 
Sec.  1.356-1(b), because the terms of the exchange specify that J 
receives 40 shares of stock of Corporation Y in exchange for J's 
Block 1 and Block 2 shares of stock of Corporation X and $200 of 
cash in exchange for J's Block 3 shares of stock of Corporation X 
and such terms are economically reasonable and the distribution is 
not dividend equivalent, such terms control. J realizes a gain of 
$80 on the exchange of Block 1, none of which is recognized under 
section 354. J realizes a

[[Page 3523]]

gain of $60 on the exchange of Block 2, none of which is recognized 
under section 354. J realizes a gain of $80 on the exchange of the 
Block 3 shares of stock of Corporation X, all of which is recognized 
under section 302(a). Under paragraph (b)(2) of this section, J has 
20 shares of Corporation Y stock, each of which has a basis of $1 
and is treated as having been acquired on Date 1, and 20 shares of 
Corporation Y stock, each of which has a basis of $2 and is treated 
as having been acquired on Date 2. Under paragraph (e) of this 
section, on or before the date on which the basis of a share of 
Corporation Y stock received becomes relevant, J may designate which 
of the shares of Corporation Y stock received have a basis of $1 and 
which have a basis of $2.
    Example 6. Stock and securities received as nonrecognition 
property. (i) Facts. J, an individual, acquired 10 shares of stock 
of Corporation X on Date 1 for $2 each, and a security issued by 
Corporation X to J on Date 2 with a principal amount of $100 and a 
basis of $100. On Date 3, Corporation Y acquires the assets of 
Corporation X in a reorganization under section 368(a)(1)(A). 
Pursuant to the terms of the plan of reorganization, J surrenders 
all of J's shares of Corporation X stock in exchange for 10 shares 
of Corporation Y stock and surrenders J's Corporation X security in 
exchange for a Corporation Y security. The distribution of neither 
the Y stock nor the Y security has the effect of a distribution of a 
dividend. On the date of the exchange, the fair market value of each 
share of stock of Corporation X is $10, the fair market value of J's 
Corporation X security is $100, the fair market value of each share 
of Corporation Y stock is $10, and the fair market value and 
principal amount of the Corporation Y security received by J is 
$100.
    (ii) Analysis. Under paragraph (b)(4) of this section and under 
Sec.  1.354-1(d), because the terms of the exchange specify that J 
receives 10 shares of stock of Corporation Y in exchange for J's 
shares of Class A stock of Corporation X and a Corporation Y 
security in exchange for its Corporation X security and such terms 
are economically reasonable, such terms control. Pursuant to section 
354, J recognizes no gain on either exchange. Under paragraph (b)(1) 
of this section, J has 10 shares of Corporation Y stock, each of 
which has a basis of $2 and is treated as having been acquired on 
Date 1, and a security that has a basis of $100 and is treated as 
having been acquired on Date 2.
    Example 7. Fewer shares of stock received than surrendered. (i) 
Facts. J, an individual, acquired 10 shares of Corporation X stock 
on Date 1 for $2 each and 10 shares of Corporation X stock on Date 2 
for $5 each. On Date 3, Corporation Y acquires the stock of 
Corporation X in a reorganization under section 368(a)(1)(B). 
Pursuant to the terms of the plan of reorganization, J receives one 
share of Corporation Y stock in exchange for every 2 shares of 
Corporation X stock. Pursuant to section 354, J recognizes no gain 
or loss on the exchange. J is not able to identify which portion of 
each share of Corporation Y stock is received in exchange for each 
share of Corporation X stock.
    (ii) Analysis. Under paragraph (b)(3) of this section, J has 5 
shares of Corporation Y stock each of which has a basis of $4 and is 
treated as having been acquired on Date 1 and 5 shares of 
Corporation Y stock each of which has a basis of $10 and is treated 
as having been acquired on Date 2. Under paragraph (e) of this 
section, on or before the date on which the basis of a share of 
Corporation Y stock received becomes relevant, J may designate which 
of the shares of Corporation Y stock received have a basis of $4 and 
which have a basis of $10.
    Example 8. Exchange described in sections 351 and 354. (i) 
Facts. J, an individual, acquired 10 shares of Corporation X stock 
on Date 1 for $3 each and 10 shares of Corporation X stock on Date 2 
for $6 each. On Date 3, Corporation Z, a newly formed, wholly owned 
subsidiary of Corporation Y, merges with and into Corporation X with 
Corporation X surviving. As part of the plan of merger, J receives 
one share of Corporation Y stock in exchange for each share of 
Corporation X stock. In connection with the transaction, Corporation 
Y assumes a liability of J. In addition, after the transaction, J 
owns stock of Corporation Y satisfying the requirements of section 
368(c). J's transfer of the Corporation X stock to Corporation Y is 
an exchange described in sections 351 and 354.
    (ii) Analysis. Under paragraph (f)(2) of this section, because, 
in connection with the transfer of the Corporation X stock to 
Corporation Y, Corporation Y assumed a liability of J, the rules of 
paragraph (g) this section apply to determine J's basis in the 
Corporation Y stock received in the transaction.
    Example 9. Reorganization in which stock is deemed received. (i) 
Facts. Each of Corporation X and Corporation Y has a single class of 
stock outstanding, all of which is owned by J, an individual. J 
acquired 100 shares of Corporation X stock on Date 1 for $1 each and 
100 shares of Corporation Y stock on Date 2 for $2 each. On Date 3, 
Corporation Y acquires the assets of Corporation X in a 
reorganization under section 368(a)(1)(D). Pursuant to the terms of 
the plan of reorganization, J surrenders J's 100 shares of 
Corporation X stock but does not receive any additional Corporation 
Y stock. Immediately before the effective time of the 
reorganization, the fair market value of each share of Corporation X 
stock and each share of Corporation Y stock is $1. Pursuant to 
section 354, J recognizes no gain or loss.
    (ii) Analysis. Under paragraph (d) of this section, J is deemed 
to have received shares of Corporation Y stock with an aggregate 
fair market value of $100 in exchange for J's Corporation X shares. 
Given the number of outstanding shares of stock of Corporation Y and 
their value immediately before the effective time of the 
reorganization, J is deemed to have received 100 shares of stock of 
Corporation Y in the reorganization. Under paragraph (b)(1) of this 
section, each of those shares has a basis of $1 and is treated as 
having been acquired on Date 1. Then, the stock of Corporation Y is 
deemed to be recapitalized in a reorganization under section 
368(a)(1)(E) in which J receives 100 shares of Corporation Y stock 
in exchange for those shares of Corporation Y stock that J held 
immediately prior to the reorganization and those shares J is deemed 
to have received in the reorganization. Under paragraph (b)(3) of 
this section, immediately after the reorganization, J holds 50 
shares of Corporation Y stock each of which has a basis of $2 and is 
treated as having been acquired on Date 1 and 50 shares of 
Corporation Y stock each of which has a basis of $4 and is treated 
as having been acquired on Date 2. Under paragraph (e) of this 
section, on or before the date on which the basis of any share of 
J's Corporation Y stock becomes relevant, J may designate which of 
the shares of Corporation Y have a basis of $2 and which have a 
basis of $4.
    Example 10. Reorganization in which stock is deemed received. 
(i) Facts. Corporation X has a single class of stock outstanding, 
all of which is owned by J, an individual. J acquired 100 shares of 
Corporation X stock on Date 1 for $1 each. Corporation Y has two 
classes of stock outstanding, common stock and nonvoting preferred 
stock. On Date 2, J acquired 100 shares of Corporation Y common 
stock for $2 each and 100 shares of Corporation Y preferred stock 
for $4 each. On Date 3, Corporation Y acquires the assets of 
Corporation X in a reorganization under section 368(a)(1)(D). 
Pursuant to the terms of the plan of reorganization, J surrenders 
J's 100 shares of Corporation X stock but does not receive any 
additional Corporation Y stock. Immediately before the effective 
time of the reorganization, the fair market value of each share of 
Corporation X stock is $10, the fair market value of each share of 
Corporation Y common stock is $10, and the fair market value of each 
share of Corporation Y preferred stock is $20. Pursuant to section 
354, J recognizes no gain or loss.
    (ii) Analysis. Under paragraph (d) of this section, J is deemed 
to have received shares of Corporation Y stock with an aggregate 
fair market value of $1,000 in exchange for J's Corporation X 
shares. Consistent with the economics of the transaction and the 
rights associated with each class of stock of Corporation Y owned by 
J, J is deemed to receive additional shares of Corporation Y common 
stock. Because the value of the common stock indicates that the 
liquidation preference associated with the Corporation Y preferred 
stock could be satisfied even if the reorganization did not occur, 
it is not appropriate to deem the issuance of additional Corporation 
Y preferred stock. Given the number of outstanding shares of common 
stock of Corporation Y and their value immediately before the 
effective time of the reorganization, J is deemed to have received 
100 shares of common stock of Corporation Y in the reorganization. 
Under paragraph (b)(1) of this section, each of those shares has a 
basis of $1 and is treated as having been acquired on Date 1. Then, 
the common stock of Corporation Y is deemed to be recapitalized in a 
reorganization under section 368(a)(1)(E) in which J receives 100 
shares of Corporation Y common stock in exchange for those shares of 
Corporation Y common stock that J held immediately prior to the 
reorganization and those shares of Corporation Y common stock that J 
is deemed to have received in the reorganization. Under paragraph 
(b)(3) of this section, immediately after the reorganization,

[[Page 3524]]

J holds 50 shares of Corporation Y common stock, each of which has a 
basis of $2 and is treated as having been acquired on Date 1, and 50 
shares of Corporation Y common stock, each of which has a basis of 
$4 and is treated as having been acquired on Date 2. Under paragraph 
(e) of this section, on or before the date on which the basis of any 
share of J's Corporation Y common stock becomes relevant, J may 
designate which of those shares have a basis of $2 and which have a 
basis of $4.
    Example 11. Distribution to which section 355 applies. (i) 
Facts. J, an individual, acquired 5 shares of Corporation X stock on 
Date 1 for $4 each and 5 shares of Corporation X stock on Date 2 for 
$8 each. Corporation X owns all of the outstanding stock of 
Corporation Y. The fair market value of the stock of Corporation X 
is $1,800. The fair market value of the stock of Corporation Y is 
$900. In a distribution to which section 355 applies, Corporation X 
distributes all of the stock of Corporation Y pro rata to its 
shareholders. In the distribution, J receives 2 shares of 
Corporation Y stock with respect to each share of Corporation X 
stock. Pursuant to section 355, J recognizes no gain or loss on the 
receipt of the shares of Corporation Y stock. J is not able to 
identify which share of Corporation Y stock is received in respect 
of each share of Corporation X stock.
    (ii) Analysis. Under paragraph (c)(1) of this section, because J 
receives 2 shares of Corporation Y stock with respect to each share 
of Corporation X stock, the basis of each share of Corporation X 
stock is allocated between such share of Corporation X stock and two 
shares of Corporation Y stock in proportion to the fair market value 
of those shares. Therefore, each of the 5 shares of Corporation X 
stock acquired on Date 1 will have a basis of $2 and each of the 10 
shares of Corporation Y stock received with respect to those shares 
will have a basis of $1. In addition, each of the 5 shares of 
Corporation X stock acquired on Date 2 will have a basis of $4 and 
each of the 10 shares of Corporation Y stock received with respect 
to those shares will have a basis of $2. Under paragraph (e) of this 
section, on or before the date on which the basis of a share of 
Corporation Y stock received becomes relevant, J may designate which 
of the shares of Corporation Y stock have a basis of $1 and which 
have a basis of $2.
    Example 12. Designation of stock surrendered and received. (i) 
Facts. J, an individual, acquired 20 shares of Corporation X stock 
on Date 1 for $2 each and 20 shares of Corporation X stock on Date 2 
for $4 each. Corporation X has 80 shares of stock outstanding. 
Corporation X owns 40 shares of stock of Corporation Y, which 
represents all of the outstanding stock of Corporation Y. The fair 
market value of the stock of Corporation X is $80. The fair market 
value of the stock of Corporation Y is $40. Corporation X 
distributes all of the stock of Corporation Y in a transaction to 
which section 355 applies. In the transaction, J surrenders 20 
shares of stock of Corporation X in exchange for 20 shares of stock 
of Corporation Y. J retains 20 shares of Corporation X stock. 
Pursuant to section 355, J recognizes no gain or loss on the receipt 
of the shares of Corporation Y stock. J is not able to identify 
which shares of Corporation X stock are surrendered. In addition, J 
is not able to identify which shares of Corporation Y stock are 
received in exchange for each surrendered share of Corporation X. In 
addition, the receipt of Y stock is not dividend equivalent.
    (ii) Analysis. Under paragraph (b)(1) of this section, J has 20 
shares of Corporation Y stock each of which is treated as received 
in exchange for one share of Corporation X stock. The basis of the 
20 shares of Corporation X stock that are retained by J will remain 
unchanged. Under paragraph (e) of this section, on or before the 
date on which the basis of a share of Corporation X or Corporation Y 
stock becomes relevant, J may designate which shares of Corporation 
X stock J surrendered in the exchange and which share of the 
Corporation Y stock received is received for each share of 
Corporation X stock surrendered. Therefore, it is possible that a 
share of Corporation Y stock would have a basis of $2 and be treated 
as having been acquired on Date 1, or would have a basis of $4 and 
be treated as having been acquired on Date 2.
    Example 13. Surrendered shares of stock or securities acquired 
on different dates or at different prices. (i) Facts. J, an 
individual, acquired 10 shares of Corporation X stock on Date 1 for 
$3 each, 10 shares of Corporation X stock on Date 2 for $18 each, 10 
shares of Corporation X stock on Date 3 for $6 each, and 10 shares 
of Corporation X stock on Date 4 for $9 each. On Date 5, Corporation 
Y acquires the assets of Corporation X in a reorganization under 
section 368(a)(1)(A). Pursuant to the terms of the plan of 
reorganization, J receives a \3/4\ share of Corporation Y stock in 
exchange for each share of Corporation X stock. Therefore, J 
receives 30 shares of Corporation Y stock. Pursuant to section 354, 
J recognizes no gain or loss on the exchange. J is not able to 
identify which shares of Corporation Y stock are received in 
exchange for each share (or portions of shares) of Corporation X 
stock.
    (ii) Analysis. Under paragraph (b)(3) of this section, J has 7 
shares of Corporation Y stock each of which has a basis of $4 and is 
treated as having been acquired on Date 1, 7 shares of Corporation Y 
stock each of which has a basis of $24 and is treated as having been 
acquired on Date 2, 7 shares of Corporation Y stock each of which 
has a basis of $8 and is treated as having been acquired on Date 3, 
and 7 shares of Corporation Y stock each of which has a basis of $12 
and is treated as having been acquired on Date 4. In addition, J has 
two shares of Corporation Y stock, each of which is divided into two 
equal segments under paragraph (b)(3) of this section. The first of 
those two shares has one segment with a basis of $2 that is treated 
as having been acquired on Date 1 and a second segment with a basis 
of $12 that is treated as having been acquired on Date 2. The second 
of those two shares has one segment with a basis of $4 that is 
treated as having been acquired on Date 3 and a second segment with 
a basis of $6 that is treated as having been acquired on Date 4. 
Under paragraph (e) of this section, on or before the date on which 
a share of Corporation Y stock received becomes relevant, J may 
designate which of the shares of Corporation Y stock have a basis of 
$4, which have a basis of $24, which have a basis of $8, which have 
a basis of $12, and which share has a split basis of $2 and $12, and 
which share has a split basis of $4 and $6.
    Example 14. Shareholder election and terms of the exchange. (i) 
Facts. J, an individual, acquired 10 shares of stock of widely-held 
Corporation X on Date 1 for $2 each, 10 shares of stock of 
Corporation X on Date 2 for $4 each, and 10 shares of stock of 
Corporation X on Date 3 for $6. On Date 5, Corporation X and 
Corporation Y sign a binding contract pursuant to which, in a 
reorganization under section 368(a)(1)(A), Corporation X will be 
merged with and into Corporation Y on Date 6. The fair market value 
of each share of Corporation X stock is $10 and the fair market 
value of each share of Corporation Y stock is $5. In exchange for 
each share of stock of Corporation X, the shareholders of 
Corporation X may elect to receive 2 shares of stock of Corporation 
Y or $10 cash. If, however, the elected consideration is 
oversubscribed, by default a pro-rata mix of consideration will be 
received for the corresponding shares of stock of Corporation X (the 
default pro-rata term). J elects to receive 2 shares of stock of 
Corporation Y in exchange for each of the 10 shares of stock of 
Corporation X acquired on Date 1, and $10 cash for each of the 
remaining 20 shares of stock of Corporation X. Neither of the 
elections is oversubscribed by the shareholders of Corporation X. 
The distribution of cash does not have the effect of a distribution 
of a dividend.
    (ii) Analysis. Under paragraph (b)(4) of this section and under 
Sec.  1.356-1(b), because the receipt does not have the effect of 
dividend, and the terms of the exchange specify that J receives 2 
shares of stock of Corporation Y in exchange for each of the 10 
shares of stock of Corporation X acquired on Date 1, and $10 cash 
for each of the remaining 20 shares of stock of Corporation X, and 
such terms are economically reasonable, such terms control. J 
realizes a gain of $80 on the exchange of the 10 shares of stock of 
Corporation X acquired on Date 1, none of which is recognized under 
Sec.  1.356-1(a). J realizes a gain of $60 on the exchange of the 10 
shares of stock of Corporation X acquired on Date 2 and realizes $40 
on the exchange of the 10 shares of stock of Corporation X acquired 
on Date 3, all of which is recognized under Sec.  1.356-1(a). Under 
paragraph (b)(2) of this section, J has 20 shares of stock of 
Corporation Y, each of which has a basis of $1 and is treated as 
having been acquired on Date 1.
    Example 15. Shareholder election and terms of the exchange. (i) 
Facts. The facts are the same as in Example 14, except that the cash 
election is oversubscribed and, pursuant to the default pro-rata 
term, for each of the shares of stock of Corporation X that J 
acquired on Date 2 and Date 3, J receives 1 share of stock of 
Corporation Y and $5 cash.
    (ii) Analysis. Under paragraph (b)(4) of this section and under 
Sec.  1.356-1(b), because the terms of the exchange specify that J 
receives 2 shares of stock of Corporation Y in exchange for each of 
the 10 shares of stock

[[Page 3525]]

of Corporation X acquired on Date 1, and 1 share of stock of 
Corporation Y and $5 cash for each of the remaining 20 shares of 
stock of Corporation X, and such terms are economically reasonable, 
such terms control. J realizes a gain of $80 on the exchange of the 
10 shares of stock of Corporation X acquired on Date 1, none of 
which is recognized under Sec.  1.356-1(a). J realizes a gain of $60 
on the exchange of the 10 shares of stock of Corporation X acquired 
on Date 2, $50 of which is recognized under Sec.  1.356-1(a), and 
$40 on the exchange of the 10 shares of stock of Corporation X 
acquired on Date 3, all of which is recognized under Sec.  1.356-
1(a). Of the 40 shares of stock of Corporation Y received by J, 20 
of the shares each has a basis of $1 and is treated as having been 
acquired on Date 1 under paragraph (b)(2) of this section, and 10 of 
the shares each has a basis of $4 and is treated as having been 
acquired on Date 2 and 10 of the shares each has a basis of $6 and 
is treated as having been acquired on Date 3 under paragraph (b)(1) 
of this section.
    Example 16. Exchange described in section 351 in which only 
stock is received. (i) Facts. J transfers Asset I, Asset II, and 50 
shares of Corporation X stock in exchange for 110 shares of 
Corporation Y in an exchange to which section 351 applies. At the 
time of the exchange, Asset I has a fair market value of $220 and a 
basis of $400, Asset II has a fair market value of $330 and a basis 
of $200, and the 50 shares of Corporation X stock each have a fair 
market value of $22 ($550 total) and a basis of $10 ($250 total). 
The fair market value of each share of Corporation Y stock is $10.
    (ii) Analysis. Pursuant to section 351(a), J recognizes no gain 
or loss on the exchange. Under paragraph (g)(2) of this section, J 
has 55 shares of Corporation Y stock each of which has a basis of 
$10.91 ($600 total, the aggregate basis of Asset I and Asset II). 
Under paragraph (g)(2) of this section, J has 55 shares of 
Corporation Y stock each of which has a basis of $4.55 ($250 total).
    Example 17. Exchange described in section 351 in which ``other 
property'' is received. (i) Facts. The facts are the same as Example 
1, except J receives 100 shares of Corporation Y stock and $100 in 
the exchange.
    (ii) Analysis. Pursuant to section 351(b), J recognizes gain, 
but no loss, on the exchange, but not in excess of the amount of 
money received. Under Sec.  1.351-2, J realizes a loss of $180 on 
Asset I, none of which is recognized, a gain of $130 on Asset II, 
$30 of which is recognized, and a gain of $300 on shares of 
Corporation X stock, $50 of which is recognized. Under paragraph 
(g)(2) of this section, J has 50 shares of Corporation Y stock each 
of which has a basis of $11.60 ($580 total), and 50 shares of 
Corporation Y stock each of which has a basis of $5.00 ($250 total).

    (j) Effective/applicability date. This section applies to exchanges 
and distributions of stock and securities that occur after the date 
these regulations are published as final regulations in the Federal 
Register, except for exchanges which occur pursuant to a written 
agreement that is binding on or before the date these regulations are 
published as final in the Federal Register. For exchanges and 
distributions of stock and securities that occur on or before the date 
these regulations are published as final regulations in the Federal 
Register, see this section as contained in 26 CFR part 1 revised April 
1, for the year before these regulations were published as final 
regulations in the Federal Register.
    Par. 15. Section 1.358-6 is amended by revising paragraphs 
(c)(1)(i)(B), (c)(3)(ii), and (f)(3) to read as follows:


Sec.  1.358-6  Stock basis in certain triangular reorganizations.

* * * * *
    (c) * * *
    (1) * * *
    (i) * * *
    (B) P transferred the T assets (and liabilities which S assumed or 
to which the T assets acquired by S were subject) to S in a transaction 
in which P received no property and P 's basis in S stock was 
determined under section 358. See Sec.  1.358-2(g)(3) (allocation of 
basis in a section 351 transaction in which stock is deemed received).
* * * * *
    (3) * * *
    (ii) P transferred the T stock to S in a transaction in which P 
received no property and P's basis in its S stock was determined under 
section 358. See Sec.  1.358-2(g)(3) (allocation of basis in a section 
351 transaction in which stock is deemed received).
* * * * *
    (f) * * *
    (3) This section applies to exchanges that occur after the date 
these regulations are published as final regulations in the Federal 
Register, except for exchanges which occur pursuant to a written 
agreement that is binding on or before the date these regulations are 
published as final in the Federal Register. For exchanges that occur on 
or before the date these regulations are published as final regulations 
in the Federal Register, see this section as contained in 26 CFR part 1 
revised April 1, 2008, for the year before the date these regulations 
are published as final regulations in the Federal Register.
    Par. 16. Section 1.368-1 is amended by adding a sentence to the end 
of paragraph (a) and by revising paragraph (e)(9) to read as follows:


Sec.  1.368-1  Purpose and scope of exception of reorganization 
exchanges.

    (a) * * * For purposes of determining whether a transaction 
qualifies as a reorganization under section 368(a), to the extent the 
terms of the exchange specify that a particular property is received in 
exchange for a particular property, such terms shall control provided 
such terms are economically reasonable.
* * * * *
    (e) * * *
    (9) This section applies to exchanges that occur after the date 
these regulations are published as final regulations in the Federal 
Register, except for exchanges which occur pursuant to a written 
agreement that is binding on or before the date these regulations are 
published as final in the Federal Register. For effective dates for 
transactions that occur on or before the date these regulations are 
published as final regulations in the Federal Register, see paragraph 
(e) of this section, as contained in 26 CFR part 1 revised April 1, for 
the year before these regulations are published as final regulations in 
the Federal Register.
* * * * *
    Par. 17. 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 other class of 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(a)(3) 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 Sec.  1.861-11(d)(1) and Sec.  1.861-11T(d)(6) with respect to 
the redeemed shareholder, then, solely for purposes of this paragraph 
(c)(2)(vi), 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

[[Page 3526]]

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. X, an unaffiliated domestic corporation that was 
organized on January 1, 2000, owns all of the stock of Y, a foreign 
corporation with a functional currency other than the U.S. dollar 
since January 1, 2000. The Y stock held by X includes Class A and 
Class B common stock. X's adjusted basis in the Class A and Class B 
common stock is $25,000 and $50,000, respectively. Y has earnings 
and profits for the 2008 taxable year of $40,000. During the 2008 
taxable year, Y redeems all of the Class A common stock held by X 
for $40,000. 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(a)(3), X's $ 
25,000 adjusted basis in the redeemed shares of Class A common stock 
is treated as a loss recognized on the date of the redemption, none 
of which is taken into account in 2008. Under paragraph (c)(2)(vi) 
of this section, solely for purposes of apportioning expenses on the 
basis of the tax book value of assets, X's adjusted basis in its 
remaining Class B common stock of Y is considered to be $75,000 
($50,000 adjusted basis in the Class B common stock plus $ 25,000 
unrecovered basis in the redeemed Class A common stock).

    (c)(2)(viii) Effective/applicability date. Paragraph (c)(2)(vi) and 
Example 3 apply to transactions that occur after the date these 
regulations are published as final regulations in the Federal Register.
    (c)(3) through (j) [Reserved]. For further guidance, see Sec.  
1.861-12T(c)(3) through (j).


Sec.  1.1002-1  [Redesignated as Sec.  1.1001-6]

    Par. 18. Section 1.1002-1 is redesignated as 1.1001-6 and amended 
by revising paragraph (c) and adding a new paragraph (e) to read as 
follows:


Sec.  1.1001-6  Sales or exchanges.

* * * * *
    (c) Certain exceptions to general rule. Exceptions to the general 
rule are made, for example, by sections 351(a), 354, 361(a), 721, 1031, 
1035, and 1036. These sections describe certain specific exchanges of 
property in which at the time of the exchange particular differences 
exist between the property parted with and the property acquired, but 
such differences are more formal than substantial. As to these, the 
Internal Revenue Code provides that such differences shall not be 
deemed controlling, and that gain or loss shall not be recognized at 
the time of the exchange. The underlying assumption of these exceptions 
is that the new property is substantially a continuation of the old 
investment still unliquidated; and, in the case of reorganizations, 
that the new enterprise, the new corporate structure and the new 
property are substantially continuations of the old still unliquidated. 
Solely for purposes of determining whether the exceptions to the 
general rule under sections 354 and 361 apply to an exchange, to the 
extent the terms of the exchange specify that a particular property is 
received in exchange for a particular property, such terms shall 
control provided such terms are economically reasonable.
* * * * *
    (e) Effective/applicability date. This section applies to exchanges 
that occur after the date these regulations are published as final 
regulations in the Federal Register. For exchanges that occur on or 
before the date these regulations are published as final regulations in 
the Federal Register, see this section as contained in 26 CFR part 1 
revised April 1, for the year before these regulations are published as 
final regulations in the Federal Register.
    Par. 19. Section 1.1016-2 is amended by adding paragraphs (e) and 
(f) to read as follows:


Sec.  1.1016-2  Items properly chargeable to capital account.

* * * * *
    (e) Solely for purposes of determining basis in stock, in the case 
of a shareholder capital contribution to which section 118 applies, the 
principles of Sec.  1.358-2(g)(3) (allocation of basis in a section 351 
transaction in which stock is deemed received) shall apply.
    (f) This section applies to transactions that occur after the date 
these regulations are published as final regulations in the Federal 
Register. For exchanges that occur on or before the date these 
regulations are published as final regulations in the Federal Register, 
see this section as contained in 26 CFR part 1 revised April 1, for the 
year before these regulations are published as final regulations in the 
Federal Register.
    Par. 20. Section 1.1374-10, the first sentence of paragraph (a) is 
revised to read as follows:


Sec.  1.1374-10  Effective date and additional rules.

    (a) In general. For transactions to which Sec.  1.302-5 applies 
[Reserved]. Sections 1.1374-1 through 1.1374-9, other than Sec.  
1.1374-3(b) and (c) Examples 2 through 4, 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. * * *
* * * * *

Linda M. Kroening,
(Acting) Deputy Commissioner for Services and Enforcement.
 [FR Doc. E9-1100 Filed 1-16-09; 8:45 am]
BILLING CODE 4830-01-P