On January 1 of Year 1, A, an individual, entered into a “life insurance contract” (as defined in § 7702 of the Internal Revenue Code (Code)) with cash value. Under the contract, A was the insured, and the named beneficiary was a member of A’s family. A had the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value. The contract in A’s hands was not property described in § 1221(a)(1)-(8).

On June 15 of Year 8, A surrendered the contract for its $78,000 cash surrender value, which reflected the subtraction of $10,000 of “cost-of-insurance” charges collected by the issuer for periods ending on or before the surrender of the contract. Through that date, A had paid premiums totaling $64,000 with regard to the life insurance contract. A had neither received any distributions under the contract nor borrowed against the contract’s cash surrender value.

A determines taxable income using the cash method of accounting and files income tax returns on a calendar year basis. As of June 15 of Year 8, A was not a terminally ill individual, nor a chronically ill individual, within the meaning of § 101(g)(4).

The facts are the same as in Situation 1, except that on June 15 of Year 8, A sold the life insurance contract for $80,000 to B, a person unrelated to A and who would suffer no economic loss upon A’s death.

The facts are the same as in Situation 1, except that the contract was a level premium fifteen-year term life insurance contract without cash surrender value. The monthly premium for the contract was $500. Through June 15 of Year 8, A paid premiums totaling $45,000 with regard to the contract. On June 15 of Year 8, A sold the life insurance contract for $20,000 to B, a person unrelated to A and who would suffer no economic loss upon A’s death.

Section 61(a) provides that, except as otherwise provided in the income tax provisions of the Code, gross income includes all income from whatever source derived, including (but not limited to) income from life insurance contracts. See § 61(a)(10). To the extent that another section of the Code or regulations provides specific treatment of any item of income, that other provision applies notwithstanding § 61 and the regulations thereunder. See § 1.61-1(b) of the Income Tax Regulations.

Section 72(e) governs the federal income tax treatment of amounts received under an annuity, endowment, or life insurance contract that are not received as an annuity. In general, under § 72(e)(2), a non-annuity amount that is received on or after the annuity starting date is included in gross income. If a non-annuity amount is received before the annuity starting date, it is included in gross income to the extent allocable to income on the contract, but not to the extent allocable to investment in the contract (i.e., it is taxed on an income-first basis).

Section 72(e)(5) provides an exception to the income-first rule in the case of -(1) certain contracts including, under § 72(e)(5)(C), life insurance contracts other than a “modified endowment contract” (as defined in § 7702A) and (2) any non-annuity amount received under a contract on its complete surrender, redemption, or maturity.

If a non-annuity amount is received under a life insurance contract other than a modified endowment contract before the annuity starting date, or is received under a life insurance contract on the complete surrender, redemption, or maturity of the contract, § 72(e)(5)(A) requires that the amount be included in gross income but only to the extent it exceeds investment in the contract. For this purpose, § 72(e)(6) defines “investment in the contract” as of any date as the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income.

In Situation 1, A received $78,000 on the complete surrender of a life insurance contract. A’s income upon surrender of the contract is determined under § 72(e)(5). Under § 72(e)(5)(A), the amount received is included in gross income to the extent it exceeds the investment in the contract. As A paid aggregate premiums of $64,000 with regard to the contract, and neither received any distributions under the contract nor borrowed against the contract’s cash surrender value prior to surrender, A’s “investment in the contract” as required by § 72(e)(6) was $64,000. Consequently, pursuant to § 72(e)(5)(A), A recognized $14,000 of income on surrender of the contract, which is the excess of $78,000 received over $64,000.

Section 72(e) does not specify whether income recognized upon the surrender of a life insurance contract is treated as ordinary income or as capital gain. Thus, the character of the income that A recognized on the surrender of the life insurance contract is capital gain only if it so qualifies under the general rules of subchapter P (§§ 1201-1260).

Section 1222(3) defines long-term capital gain as gain from the sale or exchange of a capital asset held for more than one year, if and to the extent such gain is taken into account in computing gross income. Section 1221(a) provides that the term “capital asset” means property held by the taxpayer (whether or not connected with a trade or business), but does not include items described in § 1221(a)(1)-(8). As noted above, the life insurance contract was not property described in § 1221(a)(1)-(8).

The surrender of a life insurance contract does not, however, produce a capital gain. See, e.g. , Rev. Rul. 64-51, 1964-1 C.B. 322 (noting that “[u]nder section 61(a)(10) of the Code, the proceeds received by an insured upon the surrender of, or at maturity of, a life insurance policy constitutes ordinary income to the extent such proceeds exceed the cost of the policy”). Section 1234A, originally enacted in 1981, does not change this result.

Accordingly, in Situation 1 the $14,000 of income recognized by A on the surrender of the life insurance contract is ordinary income.

Section 61(a)(3) provides that gross income includes gains derived from dealings in property.

Section 1001(a) provides that the gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis provided in § 1011 for determining gain. Thus, to determine the amount of A’s income from the sale of the life insurance contract in Situation 2, it is necessary to determine A’s amount realized from the sale, and A’s adjusted basis in the contract.

Pursuant to § 1001(b), A’s amount realized from the sale of the life insurance contract is the sum of money received from the sale, or $80,000.

Under §§ 1011 and 1012, the adjusted basis for determining gain or loss is generally the cost of the property adjusted as provided in § 1016, except as otherwise provided in subchapters O (§§ 1011 through 1092), C (§§ 301 through 386), K (§§ 701 through 777), and P (§§ 1201 through 1298). See also § 263(a); § 1.263(a)-4. Under § 1016(a)(1), proper adjustment must be made for expenditures, receipts, losses, or other items properly chargeable to capital account. See also § 1.1016-2(a). Section 72 has no bearing on the determination of the basis of a life insurance contract that is sold, because § 72 applies only to amounts received under the contract.

Both the Code and the courts acknowledge that a life insurance contract, although a single asset, may have both investment characteristics and insurance characteristics. See, e.g., § 7702 (defining life insurance contract for federal income tax purposes by reference, in part, to both the cash surrender value and death benefits under the contract); London Shoe Co. v. Commissioner, 80 F.2d 230, 231 (2d Cir. 1935) (“A life insurance policy ordinarily combines investment with insurance protection.”); Century Wood Preserving Co. v. Commissioner, 69 F.2d 967, 968 (3d Cir. 1934) (“The policies of insurance involved here have a double aspect. They provide the present protection of ordinary life insurance and also a means of investment.”). To measure a taxpayer’s gain upon the sale of a life insurance contract, it is necessary to reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale.

In Century Wood Preserving Co. v. Commissioner, 69 F.2d 967 (3d Cir. 1934), a corporate taxpayer paid $98,242 of premiums on life insurance contracts over a period of several years to insure the lives of its officers. The taxpayer then sold the contracts to the officers for their cash surrender value of $57,646, claiming a loss for the difference between the total premiums paid and the amount for which it sold the contracts. The court held that the taxpayer did not have a loss, because it did not have a basis equal to the full amount of the premiums paid:

See also London Shoe Co., 80 F.2d at 233 (noting, in the context of a situation in which the policy was surrendered, not sold, that “the cost [of the policy] was approximately reflected in the cash surrender value ... [t]he portion of the premiums not used to build up the reserve was paid to obtain insurance protection which was for many years afforded.”); Keystone Consolidated Publishing Co. v. Commissioner, 26 B.T.A. 1210, 1211 (1932) (stating “[t]otal premiums paid did not represent the cost of the [life insurance contract]. . . . [t]o so hold would be to disregard the element of insurance protection in the period prior to the sale, the benefit of which accrued to petitioner.”); § 1.1016-2(a) (cost or other basis of property adjusted for any expenditures, receipts, losses or other items properly chargeable to capital account). Compare Rev. Rul. 2009-14, page , this Bulletin (not requiring a reduction for cost of insurance charges imposed after a preexisting life insurance contract was purchased for profit by a taxpayer with no insurable interest in the insured).

In Situation 2, A paid total premiums of $64,000 under the life insurance contract through the date of sale, and $10,000 was subtracted from the contract’s cash surrender value as cost-of-insurance charges. Accordingly, A’s adjusted basis in the contract as of the date of sale under §§ 1011 and 1012 and the authorities cited above was $54,000 ($64,000 premiums paid less $10,000 expended as cost of insurance).

Accordingly, A must recognize $26,000 on the sale of the life insurance contract to B, which is the excess of the amount realized on the sale ($80,000) over A’s adjusted basis of the contract ($54,000).

Unlike Situation 1, which involves the surrender of the life insurance contract to the issuer of the contract, Situation 2 involves an actual sale of the contract. Nevertheless some or all of the gain on the sale of the contract may be ordinary if the substitute for ordinary income doctrine applies.

The Supreme Court has held, under the so-called “substitute for ordinary income” doctrine, that “property” within the meaning of § 1221 does not include claims or rights to ordinary income. Instead, the Court “has consistently construed ‘capital asset’ to exclude property representing income items or accretions to the value of a capital asset themselves properly attributable to income.” United States v. Midland-Ross Corp., 381 U.S. 54, 57 (1965). See also Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958) (consideration received on the sale of a working interest in an oil well represented a substitute for what would have been received in the future as ordinary income, therefore taxable as ordinary income and not capital gain); Arkansas Best Corp. v. Commissioner, 485 U.S. 212, 217, n.5 (1988) (noting that the “substitute for ordinary income” doctrine had no application to that case). Thus, ordinary income that has been earned but not recognized by a taxpayer cannot be converted into capital gain by a sale or exchange. See also Prebola v. Commissioner, 482 F.3d 610 (2d Cir. 2007); United States v. Maginnis, 356 F.3d 1179 (9^th Cir. 2004); Davis v. Commissioner, 119 T.C. 1 (2002) (applying the “substitute for ordinary income” doctrine after the Arkansas Best decision).

The “substitute for ordinary income” doctrine has been applied to characterize the profit on a sale of an annuity contract or life insurance contract as ordinary income. For example, in Gallun v. Commisssioner, 327 F.2d 809, 811 (7th Cir. 1964), the court stated:

Application of the “substitute for ordinary income” doctrine is limited to the amount that would be recognized as ordinary income if the contract were surrendered (i.e., to the inside build-up under the contract). Hence, if the income recognized on the sale or exchange of a life insurance contract exceeds the “inside build-up” under the contract, the excess may qualify as gain from the sale or exchange of a capital asset. See, e.g., Commissioner v. Phillips, 275 F.2d 33, 36 n. 3 (4^th Cir. 1960).

In Situation 2, the inside build-up under A’s life insurance contract immediately prior to the sale to B was $14,000 ($78,000 cash surrender value less $64,000 aggregate premiums paid). Hence, $14,000 of the $26,000 of income that A must recognize on the sale of the contract is ordinary income under the “substitute for ordinary income” doctrine. Because the life insurance contract in A’s hands was not property described in § 1221(a)(1)-(8) and was held by A for more than one year, the remaining $12,000 of income is long-term capital gain within the meaning of § 1222(3).

In Situation 3, the amount realized from the sale of the term life insurance contract is the sum of money received from the sale, or $20,000.

A’s adjusted basis in the life insurance contract for purposes of determining its gain or loss on sale is equal to the total premiums paid under the contract, less charges for the provision of insurance before the sale. Absent other proof, the cost of the insurance provided to A each month is presumed to equal the monthly premium under the contract, or $500. The cost of the insurance protection provided to A during the 89.5 month period that A held the contract was $500 times 89.5 months, or $44,750. Hence, A’s adjusted basis in the contract on the date of the sale to B was $250 ($45,000 total premiums paid, less $44,750 cost of insurance protection).

Accordingly, A must recognize $19,750 on the sale of the term life insurance contract to B in Situation 3, which is the excess of the amount realized on the sale ($20,000) over the adjusted basis of the contract ($250).

In Situation 3, the term life insurance contract had no cash surrender value. Hence, there was no inside buildup under the contract to which the substitute for ordinary income doctrine could apply. Because the life insurance contract in A’s hands was not property described in § 1221(a)(1)-(8) and was held by A for more than one year, the $19,750 of income that A must recognize on the sale of the contract is long-term capital gain within the meaning of § 1222(3).

A is a United States citizen residing in the United States. B is a United States person as defined in § 7701(a)(30) of the Internal Revenue Code (Code). B determines taxable income using the cash method of accounting and files its income tax returns on a calendar year basis.

On June 15, 2008, B purchased from A for $20,000 a “life insurance contract” (as defined in § 7702) on the life of A. The contract was originally issued by IC, a domestic corporation, to A on January 1, 2001. The contract was a level premium fifteen-year term life insurance contract without cash surrender value. At the time of purchase, the remaining term of the contract was 7 years, 6 months, and 15 days. The monthly premium for the contract was $500, due and payable on the first day of each month. As owner of the contract, B had the right to change the beneficiary and, pursuant to that right, named itself beneficiary under the contract immediately after acquiring the contract.

B had no insurable interest in A’s life and, except for the purchase of the contract, B had no relationship to A and would suffer no economic loss upon A’s death. B purchased the contract with a view to profit. The contract in B’s hands was not property described in § 1221(a)(1)-(8). The likelihood that B would allow the contract to lapse by failing to pay any of the remaining premiums was remote.

On December 31, 2009, A died, and IC paid $100,000 under the life insurance contract to B by reason of A’s death. Through that date, B had paid monthly premiums totaling $9,000 to keep the contract in force.

The facts are the same as in Situation 1, except that A did not die and, on December 31, 2009, B sold the contract to C (a person unrelated to A or B) for $30,000.

The facts are the same as in Situation 1, except that B is a foreign corporation that is not engaged in a trade or business within the United States (including the trade or business of purchasing, or taking assignments of, life insurance contracts).

Section 61(a) provides that, except as otherwise provided in the income tax provisions of the Code, gross income includes all income from whatever source derived, including (but not limited to) income from life insurance contracts. See § 61(a)(10). To the extent that another section of the Code or regulations provides specific treatment of any item of income, that other provision applies notwithstanding § 61 and the regulations thereunder. See § 1.61-1(b) of the Income Tax Regulations.

Section 72(e) governs the federal income tax treatment of amounts received under an annuity, endowment, or life insurance contract that are not received as an annuity. In general, under § 72(e)(2), a non-annuity amount that is received on or after the annuity starting date is included in gross income. If a non-annuity amount is received before the annuity starting date, it is included in gross income to the extent allocable to income on the contract, but not to the extent allocable to investment in the contract (i.e., it is taxed on an income-first basis).

Section 72(e)(5) provides an exception to the income-first rule in the case of -(1) certain contracts including, under § 72(e)(5)(C), life insurance contracts other than a “modified endowment contract” (as defined in § 7702A) and (2) any non-annuity amount received under a contract on its complete surrender, redemption, or maturity.

If a non-annuity amount is received under a life insurance contract other than a modified endowment contract before the annuity starting date, or is received under a life insurance contract on the complete surrender, redemption, or maturity of the contract, § 72(e)(5)(A) requires that the amount be included in gross income but only to the extent it exceeds investment in the contract. For this purpose, § 72(e)(6) defines “investment in the contract” as of any date as the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amounts was excludable from gross income. In the case of a transferee for value, only the actual value of consideration paid for the contract, plus premiums and other consideration paid after the transfer, is taken into account. See generally § 72(g); § 1.72-10.

Section 101(a)(1) provides, generally, that gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. In the case of a transfer for valuable consideration, however, § 101(a)(2) provides that the amount excluded from gross income shall not exceed an amount equal to the sum of the actual value of the consideration paid and the premiums and other amounts subsequently paid by the transferee. The “transfer for value” rule of § 101(a)(2) does not apply in the case of a transfer involving a carryover basis or in the case of a transfer to the insured, a partner of the insured, a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.

In Situation 1, B received $100,000 from IC by reason of the death of A, the insured under the contract. Because B purchased the contract from A in exchange for a purchase price of $20,000, B’s acquisition of the contract was a “transfer for a valuable consideration” within the meaning of § 101(a)(2). Neither the carryover basis exception of § 101(a)(2)(A) nor the exception for transfers involving parties related to the insured under § 101(a)(2)(B) applied. Accordingly, § 101(a)(1) excludes from B’s gross income the amount received by reason of A’s death, but § 101(a)(2) limits the exclusion to the sum of the actual value of the consideration paid for the transfer ($20,000) and other amounts paid by B ($9,000), or $29,000. B therefore must include in gross income $71,000, which is the difference between the total death benefit received ($100,000) and the amount excluded under § 101 ($29,000).

Neither § 61(a) nor § 72(e) specifies whether taxable amounts of death benefits received by a transferee for value of a life insurance contract by reason of the death of the insured are treated as ordinary income or as capital gain. Thus, the character of the income that B recognized upon receipt of death benefits under the contract is capital gain only if it so qualifies under the general rules of subchapter P (§§ 1201-1260).

Section 1222(3) defines long-term capital gain as gain from the sale or exchange of a capital asset held for more than one year if and to the extent such gain is taken into account in computing gross income. Section 1221(a) provides that the term “capital asset” means property held by the taxpayer (whether or not connected with a trade or business), but does not include items described in § 1221(a)(1)-(8). The life insurance contract in B’s hands was not property described in § 1221(a)(1)-(8), and was thus a capital asset in B’s hands.

Neither the surrender of a life insurance or annuity contract nor the receipt of a death benefit from the issuer under the terms of the contract produces a capital gain. Accordingly, the $71,000 income recognized by B upon the receipt of death benefits under the contract is ordinary income.

Section 1001(a) provides that the gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis provided in § 1011 for determining gain. Thus, to determine the amount of B’s income from the sale of the life insurance contract to C, it is necessary to determine B’s amount realized from the sale, and B’s adjusted basis in the contract.

Pursuant to § 1001(b), B’s amount realized from the sale of the life insurance contract is the sum of money received from the sale, or $30,000.

Under §§ 1011 and 1012, the adjusted basis for determining gain or loss is generally the cost of the property as adjusted provided in § 1016, except as otherwise provided in subchapters O (§§ 1011 through 1092), C (§§ 301 through 386), K (§§ 702 through 777), and P (§§ 1201 through 1298). Section 101(a)(2) has no bearing on the determination of the basis of a life insurance contract that is sold, because § 101(a)(2) applies only to amounts received by reason of the death of the insured.

The starting point for determining the basis of a life insurance contract for purposes of measuring gain on its sale is its cost. Section 1.263(a)-4(c)(1)(iv) requires taxpayers to capitalize an amount paid to another party to acquire an intangible (including a life insurance contract) from that party in a purchase or similar transaction. In Situation 2, B paid $20,000 to A to acquire the life insurance contract from A, which is included in B’s cost basis.

In Situation 2, B also paid $9,000 in monthly premiums to prevent the contract from lapsing. No deduction is allowed for these monthly premiums under section 264. However, § 1.263(a)-4(b)(1)(iv) authorizes the Service and Treasury to publish guidance in the Internal Revenue Bulletin that identifies a future benefit as an intangible for which capitalization is required. The premiums paid by a secondary market purchaser of a term life insurance contract serve to create or enhance a future benefit for which capitalization is appropriate. Accordingly, this revenue ruling requires a secondary market purchaser to capitalize premiums paid to prevent a term life insurance contract (without cash value) from lapsing. The Service will not challenge the capitalization of such premiums paid or incurred prior to the issuance of this ruling.

In Situation 2, B paid $20,000 to acquire the life insurance contract and $9,000 in monthly premiums to prevent the contract from lapsing. Therefore, B’s adjusted basis for purposes of measuring gain on the sale to C was $29,000.

In Rev. Rul. 2009-13, page , this Bulletin, Situation 2, a taxpayer paid premiums totaling $64,000 with regard to a life insurance contract, and $10,000 of “cost of insurance” charges were subtracted from the contract’s cash surrender value. The taxpayer sold the contract for $80,000. The ruling concludes that the taxpayer’s gain on the sale was equal to $26,000, representing the $80,000 amount realized less $54,000 adjusted basis ($64,000 total premiums paid minus $10,000 cost of insurance charges). The ruling notes that on these facts, the reduction for cost of insurance charges is necessary to account for the insurance protection the taxpayer received before the sale. Similarly, in Century Wood Preserving Co. v. Commissioner, 69 F.2d 967 (3rd Cir. 1934), the court concluded that a taxpayer who sold a life insurance contract could not include in basis amounts that were used to provide annual insurance protection. See also London Shoe Co. v. Commissioner, 80 F.2d 230 (2d Cir. 1935); Keystone Consolidated Publishing Co. v. Commissioner, 26 B.T.A. 1210 (1932).

B is not required to reduce its basis in the life insurance contract by any cost of insurance charges that may have been imposed. In Rev. Rul. 2009-13, Century Wood Preserving, London Shoe, and Keystone Consolidated, adjusted basis was reduced by cost of insurance charges because those charges represented the cost of insurance protection that was enjoyed by the policyholder as the beneficiary of the policy. In contrast, in Situation 2, B is wholly unrelated to A and did not purchase the life insurance contract for protection against any economic loss upon A’s death. B acquired and held the contract solely with a view to profit, and paid additional premiums to prevent the lapse of B’s purely financial investment, the contract. Situation 2 is thus distinguishable from Rev. Rul. 2009-13 and the authorities cited therein.

As the amount realized on B’s sale of the life insurance contract to C was $30,000, and the adjusted basis was $29,000, B must recognize $1,000 on the sale to C in Situation 2.

Because the term life insurance contract was not property described in § 1221(a)(1)-(8) and was held for more than one year, the $1,000 of gain recognized by B under § 1001 upon the sale of the contract to C is long-term capital gain. Rev. Rul. 2009-13. Additionally, the contract was a term contract without any cash value. Hence, the substitute for ordinary income doctrine under United States v. Midland Ross, 381 U.S. 54 (1965), and its progeny does not apply.

As in Situation 1, B must recognize $71,000 of income upon the receipt of death benefits. This income is “fixed or determinable annual or periodical” income within the meaning of § 881(a)(1). See § 1.1441-2(b); Rev. Rul. 64-51, 1964-1 C.B. 322; Rev. Rul. 2004-75, 2004-2 C.B. 109. Consequently, B is subject to tax under § 881(a) with respect to this income, if the income is from sources within the United States.

Section 861(a)(1) provides that interest received from a domestic corporation is generally from sources within the United States.

Section 861(a)(7) provides that premiums received from the issuance of any life insurance contract are generally income from sources within the United States when the premiums are derived in connection with a life insurance contract issued in respect of the lives of residents of the United States.

Section 865 provides that the source of income from the sale of personal property is generally determined by reference to the residence of the taxpayer.

When the source of an item of income is not specified by statute or by regulation, courts have determined the source of the item by comparison and analogy to classes of income specified within the statute. See Bank of America v. United States, 680 F.2d 142, 147 (Ct. Cl. 1982); Howkins v. Commissioner, 49 T.C. 689 (1968); Clayton v. United States, 33 Fed. Cl. 628 (1995), aff’d without published opinion, 91 F.3d 170 (Fed. Cir. 1996), cert. denied, 519 U.S. 1040 (1996). See also Rev. Rul. 79-388, 1979-2 C.B. 270.

The Code does not specify the source of income resulting from the payment of death benefits pursuant to a term life insurance contract. See also Rev. Rul. 2004-75. Consequently, the source of such income is determined by comparison and analogy to classes of income that are specified within the statute.

In the current situation, A is a United States citizen residing in the United States, and IC is a domestic corporation. B’s income is from sources within the United States.

On January 1, 2009, X, a calendar year taxpayer, is organized in State as an unincorporated entity that is classified as a partnership for federal tax purposes. X elects under § 301.7701-3(c)(1)(i) of the Procedure and Administrative Regulations to be treated as an association for federal tax purposes, effective January 1, 2010. On February 1, 2010, X files an election under section 1362(a) of the Internal Revenue Code to be taxed as an S corporation, effective January 1, 2010. There is no person who held stock in X on January 1, 2010, who does not hold stock at the time the election is made.

On January 1, 2009, Y, a calendar year taxpayer, is organized in State as an unincorporated entity that is classified as a partnership for federal tax purposes. Y converts into a corporation under a state law formless conversion statute, effective January 1, 2010. As a result of the conversion, Y is classified as a corporation for federal tax purposes. On February 1, 2010, Y files an election under section 1362(a) to be taxed as an S corporation, effective January 1, 2010. There is no person who held stock in Y on January 1, 2010, who does not hold stock at the time the election is made.

When X, an entity classified as a partnership for federal tax purposes, elects under § 301.7701-3(c)(1)(i) to be classified as an association for federal tax purposes, the following steps are deemed to occur: X contributes all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter X liquidates by distributing the stock of the association to its partners. Under § 301.7701-3(g)(3)(i), these deemed steps are treated as occurring immediately before the close of the day before the election is effective. Thus, the partnership’s taxable year ends on December 31, 2009, and the association’s first taxable year begins on January 1, 2010. Therefore, the partnership will not be deemed to own the stock of the association during any portion of the association’s first taxable year beginning January 1, 2010, and X is eligible to elect to be an S corporation effective January 1, 2010. Additionally, because the partnership’s taxable year ends immediately before the close of the day on December 31, 2009, and the association’s first taxable year begins at the start of the day on January 1, 2010, the deemed steps will not cause X to have an intervening short taxable year in which it was a C corporation.

Rev. Rul. 2004-59 provides that the conversion of a partnership into a state law corporation under a state law formless conversion statute is treated in the same manner as if the entity had made an election to be treated as an association under § 301.7701-3(c)(1)(i). Therefore, Y is deemed to contribute all of its assets and liabilities to the corporation in exchange for stock in the corporation, and immediately thereafter Y liquidates by distributing the stock of the corporation to its partners. As in Situation 1, the partnership will not be deemed to own the stock of the corporation during any portion of the corporation’s first taxable year beginning January 1, 2010, and Y is eligible to elect to be an S corporation effective January 1, 2010. Additionally, because the partnership’s taxable year ends immediately before the close of the day on December 31, 2009, and the corporation’s first taxable year begins at the start of the day on January 1, 2010, the deemed steps will not cause Y to have an intervening short taxable year in which it was a C corporation.

The final regulations that are the subject of this document are under section 367(a) of the Internal Revenue Code.

The final regulations (T.D. 9446) that were published in the Federal Register on February 11, 2009, inadvertently removed Treas. Reg. §1.367(a)-3T in its entirety rather than removing §1.367(a)-3T(e), (f)(1), (f)(2), and the second sentence of §1.367(a)-3T(f)(3). This document correctly adds the text of §1.367(a)-3T back into the Code of Federal Regulations.

* * * * *

Accordingly, 26 CFR Part 1 is corrected by making the following correcting amendments:

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

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

Par. 2. Section 1.367(a)-3T is added to read as follows:

(a) through (b)(2)(i)(B) [Reserved]. For further guidance, see §1.367(a)-3(a) through (b)(2)(i)(B).

(b)(2)(i)(C) If in connection with a transaction described in §1.367(b)-14T, one or more U.S. persons transfer stock of T, as defined in §1.358-6(b)(1)(iii), to a corporation in a transfer described in section 367(a), and the amount of gain in the T stock that would otherwise be recognized under section 367(a) is less than the deemed distribution that would result from the adjustments made under §1.367(b)-14T and that would be treated as a dividend under section 301(c)(1), then section 367(b), and not section 367(a), shall apply to such transaction. This paragraph (b)(2)(i)(C) applies to transfers occurring on or after May 23, 2008.

(b)(2)(ii) through (f) [Reserved]. For further guidance, see §1.367(a)-3(b)(2)(ii) through (f).

(g) Effective/applicability date. Paragraph (b)(2)(i)(C) of this section applies to transfers occurring on or after May 23, 2008.

(h) Expiration date. The applicability of paragraph (b)(2)(i)(C) of this section expires on May 23, 2011.

Par. 3. Section 1.367(a)-8(r)(2) is amended by revising the paragraph heading to read as follows:

(2) Applicability to transfers occurring before March 13, 2009—(i) * * *

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