(a) * * *

(4) * * *

(ix) A purchase money obligation given by the lessor to the lessee (or a party that is related to the lessee) in a sale and leaseback transaction involving an agreement qualifying as a lease under §5c.168(f)(8)-1 through §5c.168(f)(8)-11 of this chapter. See §5c.168(f)(8)-1(e) Example (2) of this chapter.

* * * * *

(a) * * *

(3) Section 1.263A-9(a)(4)(ix) generally applies to interest incurred in taxable years beginning on or after May 20, 2004. In the case of property that is inventory in the hands of the taxpayer, §1.263A-9(a)(4)(ix) applies to taxable years beginning on or after May 20, 2004. Taxpayers may elect to apply §1.263A-9(a)(4)(ix) to interest incurred in taxable years beginning on or after January 1, 1995, or, in the case of property that is inventory in the hands of the taxpayer, to taxable years beginning on or after January 1, 1995. A change in a taxpayer’s treatment of interest to a method consistent with §1.263A-9(a)(4)(ix) is a change in method of accounting to which sections 446 and 481 apply.

* * * * *

(a) IRS records or information means any material (including copies thereof) contained in the files (including paper, electronic or other media files) of the Internal Revenue Service (IRS), any information relating to material contained in the files of the IRS, or any information acquired by an IRS officer or employee, while an IRS officer or employee, as a part of the performance of official duties or because of that IRS officer’s or employee’s official status with respect to the administration of the internal revenue laws or any other laws administered by or concerning the IRS. IRS records or information includes, but is not limited to, returns and return information as those terms are defined in section 6103(b)(1) and (2) of the Internal Revenue Code (Code), tax convention information as defined in section 6105 of the Code, information gathered during Bank Secrecy Act and money laundering investigations, and personnel records and other information pertaining to IRS officers and employees. IRS records and information also includes information received, generated or collected by an IRS contractor pursuant to the contractor’s contract or agreement with the IRS. The term does not include records or information obtained by IRS officers and employees, solely for the purpose of a federal grand jury investigation, while under the direction and control of the United States Attorney’s Office. The term IRS records or information nevertheless does include records or information obtained by the IRS before, during, or after a Federal grand jury investigation if the records or information are obtained—

(1) At the administrative stage of a criminal investigation (prior to the initiation of the grand jury);

(2) From IRS files (such as transcripts or tax returns); or

(3) For use in a subsequent civil investigation.

(b) IRS officers and employees means all officers and employees of the United States appointed by, employed by, or subject to the directions, instructions, or orders of the Commissioner or IRS Chief Counsel and also includes former officers and employees.

(c) IRS contractor means any person, including the person’s current and former employees, maintaining IRS records or information pursuant to a contract or agreement with the IRS, and also includes former contractors.

(d) A request is any request for testimony of an IRS officer, employee or contractor or for production of IRS records or information, oral or written, by any person, which is not a demand.

(e) A demand is any subpoena or other order of any court, administrative agency or other authority, or the Congress, or a committee or subcommittee of the Congress, and any notice of deposition (either upon oral examination or written questions), request for admissions, request for production of documents or things, written interrogatories to parties, or other notice of, request for, or service for discovery in a matter before any court, administrative agency or other authority.

(f) An IRS matter is any matter before any court, administrative agency or other authority in which the United States, the Commissioner, the IRS, or any IRS officer or employee acting in an official capacity, or any IRS officer or employee (including an officer or employee of IRS Office of Chief Counsel) in his or her individual capacity if the United States Department of Justice or the IRS has agreed to represent or provide representation to the IRS officer or employee, is a party and that is directly related to official business of the IRS or to any law administered by or concerning the IRS, including, but not limited to, judicial and administrative proceedings described in section 6103(h)(4) and (l)(4) of the Internal Revenue Code.

(g) An IRS congressional matter is any matter before the Congress, or a committee or subcommittee of the Congress, that is related to the administration of the internal revenue laws or any other laws administered by or concerning the IRS, or to IRS records or information.

(h) A non-IRS matter is any matter that is not an IRS matter or an IRS congressional matter.

(i) A testimony authorization is a written instruction or oral instruction memorialized in writing within a reasonable period by an authorizing official that sets forth the scope of and limitations on proposed testimony and/or disclosure of IRS records or information issued in response to a request or demand for IRS records or information. A testimony authorization may grant or deny authorization to testify or disclose IRS records or information and may make an authorization effective only upon the occurrence of a precedent condition, such as the receipt of a consent complying with the provisions of section 6103(c) of the Code. To authorize testimony means to issue the instruction described in this paragraph (i).

(j) An authorizing official is a person with delegated authority to authorize testimony and the disclosure of IRS records or information.

(a) Situations in which disclosure shall not be authorized. Authorizing officials shall not permit testimony or disclosure of IRS records or information in response to requests or demands if testimony or disclosure of IRS records or information would—

(1) Violate a Federal statute including, but not limited to, sections 6103 or 6105 of the Internal Revenue Code (Code), the Privacy Act of 1974 (5 U.S.C. 552a), or a rule of procedure, such as the grand jury secrecy rule, Fed. R. Crim. P. 6(e);

(2) Violate a specific Federal regulation, including, but not limited to, 31 CFR 103.53;

(3) Reveal classified national security information, unless properly declassified;

(4) Reveal the identity of an informant; or

(5) Reveal investigatory records or information compiled for law enforcement purposes that would permit interference with law enforcement proceedings or would disclose investigative techniques and procedures, the effectiveness of which could thereby be impaired.

(b) Assertion of privileges. Any applicable privilege or protection under law may be asserted in response to a request or demand for testimony or disclosure of IRS records or information, including, but not limited to, the following—

(1) Attorney-client privilege;

(2) Attorney work product doctrine; and

(3) Deliberative process (executive) privilege.

(c) Non-IRS matters. If any person makes a request or demand for IRS records or information in connection with a non-IRS matter, authorizing officials shall take into account the following additional factors in responding to the request or demand—

(1) Whether the requester is a Federal agency, or a state or local government or agency thereof;

(2) Whether the demand was issued by a Federal or state court, administrative agency or other authority;

(3) The potential effect of the case on the administration of the internal revenue laws or any other laws administered by or concerning the IRS;

(4) The importance of the legal issues presented;

(5) Whether the IRS records or information are available from other sources;

(6) The IRS’s anticipated commitment of time and anticipated expenditure of funds necessary to comply with the request or demand;

(7) The number of similar requests and their cumulative effect on the expenditure of IRS resources;

(8) Whether the request or demand allows a reasonable time for compliance (generally, at least fifteen business days);

(9) Whether the testimony or disclosure is appropriate under the rules of procedure governing the case or matter in which the request or demand arises;

(10) Whether the request or demand involves expert witness testimony;

(11) Whether the request or demand is for the testimony of an IRS officer, employee or contractor who is without personal knowledge of relevant facts;

(12) Whether the request or demand is for the testimony of a presidential appointee or senior executive and whether the testimony of a lower-level official would suffice;

(13) Whether the procedures in §301.9000-5 have been followed; and

(14) Any other relevant factors that may be brought to the attention of the authorizing official.

(a) Prohibition on disclosure of IRS records or information without testimony authorization. Except as provided in paragraph (b) of this section, when a request or demand for IRS records or information is made, no IRS officer, employee or contractor shall testify or disclose IRS records or information to any court, administrative agency or other authority, or to the Congress, or to a committee or subcommittee of the Congress without a testimony authorization. However, an IRS officer, employee or contractor may appear in person to advise that he or she is awaiting instructions from an authorizing official with respect to the request or demand.

(b) Exceptions. No testimony authorization is required in the following circumstances—

(1) To respond to a request or demand for IRS records or information by the attorney or other government representative representing the IRS in a particular IRS matter;

(2) To respond solely in writing, under the direction of the attorney or other government representative, to requests and demands in IRS matters, including, but not limited to, admissions, document production, and written interrogatories to parties;

(3) To respond to a request or demand issued to a former IRS officer, employee or contractor for expert or opinion testimony if the testimony sought from the former IRS officer, employee or contractor involves general knowledge (such as information contained in published procedures of the IRS or the IRS Office of Chief Counsel) gained while the former IRS officer, employee or contractor was employed or under contract with the IRS; or

(4) If a more specific procedure established by the Commissioner governs the disclosure of IRS records or information. These procedures include, but are not limited to, those relating to: procedures pursuant to §601.702(d) of this chapter; Freedom of Information Act requests pursuant to 5 U.S.C. 552; Privacy Act of 1974 requests pursuant to 5 U.S.C. 552a; disclosures to state tax agencies pursuant to section 6103(d) of the Internal Revenue Code (Code); and disclosures to the United States Department of Justice pursuant to an ex parte order under section 6103(i)(1) of the Code.

(c) Disclosures of IRS records or information with or without testimony authorization must be permitted under other applicable law. Any disclosure of IRS records or information that is otherwise permissible under this section must not be prohibited under applicable law. For example, in a case in which returns and return information may be disclosed, the disclosure must be authorized under section 6103, even if any required testimony authorization is obtained. If tax convention information (as defined under section 6105) may be disclosed, in deciding whether the disclosure is authorized, the authorizing official must coordinate the disclosure with the U.S. Competent Authority.

(a) Purpose and scope. This section prescribes procedures to be followed by IRS officers, employees and contractors upon receipt of a request or demand in matters in which a testimony authorization is or may be required.

(b) Notification of the Disclosure Officer. Except as provided in paragraphs (c), (d), and (e) of this section, an IRS officer, employee or contractor who receives a request or demand for IRS records or information for which a testimony authorization is or may be required shall notify promptly the disclosure officer servicing the IRS officer’s, employee’s or contractor’s geographic area. The IRS officer, employee or contractor shall await instructions from the authorizing official concerning the response to the request or demand. An IRS officer, employee, or contractor who receives a request or demand in one of the following matters should not notify the disclosure officer, but should follow the instructions in paragraph (c), (d), or (e) of this section, as applicable:

(1) United States Tax Court cases.

(2) Personnel matters, labor relations matters, government contract matters, matters related to informant claims or matters related to the rules of Bivens v. Six Unknown Named Agents of Federal Bureau of Narcotics, 403 U.S. 388 (1971) (Bivens matters), or matters under the Federal Tort Claims Act (FTCA).

(3) IRS congressional matters.

(c) Requests or demands in United States Tax Court cases. An IRS officer, employee or contractor who receives a request or demand for IRS records or information on behalf of a petitioner in a United States Tax Court case shall notify promptly the IRS Office of Chief Counsel attorney assigned to the case. The IRS Office of Chief Counsel attorney shall notify promptly the authorizing official. The IRS officer, employee or contractor who received the request or demand shall await instructions from the authorizing official.

(d) Requests or demands in personnel, labor relations, government contract, Bivens or FTCA matters, or matters related to informant claims. An IRS officer, employee or contractor who receives a request or demand, on behalf of an appellant, grievant, complainant or representative, for IRS records or information in a personnel, labor relations, government contract, Bivens or FTCA matter, or matter related to informant claims, shall notify promptly the IRS Associate Chief Counsel (General Legal Services) attorney assigned to the case. If no IRS Associate Chief Counsel (General Legal Services) attorney is assigned to the case, the IRS officer, employee or contractor shall notify promptly the IRS Associate Chief Counsel (General Legal Services) attorney servicing the geographic area. The IRS Associate Chief Counsel (General Legal Services) attorney shall notify promptly the authorizing official. The IRS officer, employee or contractor who received the request or demand shall await instructions from the authorizing official.

(e) Requests or demands in IRS congressional matters. An IRS officer, employee or contractor who receives a request or demand in an IRS congressional matter shall notify promptly the IRS Office of Legislative Affairs. The IRS officer, employee or contractor who received the request or demand shall await instructions from the authorizing official.

(f) Opposition to a demand for IRS records or information in IRS and non-IRS matters. If, in response to a demand for IRS records or information, an authorizing official has not had a sufficient opportunity to issue a testimony authorization, or determines that the demand for IRS records or information should be denied, the authorizing official shall request the government attorney or other representative of the government to oppose the demand and respectfully inform the court, administrative agency or other authority, by appropriate action, that the authorizing official either has not yet issued a testimony authorization, or has issued a testimony authorization to the IRS officer, employee or contractor that denies permission to testify or disclose the IRS records or information. If the authorizing official denies authorization in whole or in part, the government attorney or other representative of the government shall inform the court, administrative agency or other authority of the reasons the authorizing official gives for not authorizing the testimony or the disclosure of the IRS records or information or take other action in opposition as may be appropriate (including, but not limited to, filing a motion to quash or a motion to remove to Federal court).

(g) Procedure in the event of an adverse ruling. In the event the court, administrative agency, or other authority rules adversely with respect to the refusal to disclose the IRS records or information pursuant to the testimony authorization, or declines to defer a ruling until a testimony authorization has been received, the IRS officer, employee or contractor who has received the request or demand shall, pursuant to this section, respectfully decline to testify or disclose the IRS records or information.

(h) Penalties. Any IRS officer or employee who discloses IRS records or information without following the provisions of this section or §301.9000-3, may be subject to administrative discipline, up to and including dismissal. Any IRS officer, employee or contractor may be subject to applicable contractual sanctions and civil or criminal penalties, including prosecution under 5 U.S.C. 552a(i), for willful disclosure in an unauthorized manner of information protected by the Privacy Act of 1974, or under section 7213 of the Internal Revenue Code, for willful disclosure in an unauthorized manner of return information.

(i) No creation of benefit or separate privilege. Nothing in §§301.9000-1 through 301.9000-3, this section, and §§301.9000-5 and 301.9000-6, creates, is intended to create, or may be relied upon to create, any right or benefit, substantive or procedural, enforceable at law by a party against the United States. Nothing in these regulations creates a separate privilege or basis to withhold IRS records or information.

(a) Written statement. A request or demand for IRS records or information for use in a non-IRS matter shall be accompanied by a written statement made by or on behalf of the party seeking the testimony or disclosure of IRS records or information, setting forth—

(1) A brief description of the parties to and subject matter of the proceeding and the issues;

(2) A summary of the testimony, IRS records or information sought, the relevance to the proceeding, and the estimated volume of IRS records involved;

(3) The time that will be required to present the testimony (on both direct and cross examination);

(4) Whether any of the IRS records or information is a return or is return information (as defined in section 6103(b) of the Internal Revenue Code (Code)), or tax convention information (as defined in section 6105(c)(1) of the Code), and the statutory authority for the disclosure of the return or return information (and, if no consent to disclose pursuant to section 6103(c) of the Code accompanies the request or demand, the reason consent is not necessary);

(5) Whether a declaration of an IRS officer, employee or contractor under penalties of perjury pursuant to 28 U.S.C. 1746 would suffice in lieu of deposition or trial testimony;

(6) Whether deposition or trial testimony is necessary in a situation in which IRS records may be authenticated without testimony under applicable rules of evidence and procedure;

(7) Whether IRS records or information are available from other sources; and

(8) A statement that the request or demand allows a reasonable time (generally at least fifteen business days) for compliance.

(b) Permissible waiver of statement. The requirement of a written statement in paragraph (a) of this section may be waived by the authorizing official for good cause.

The following examples illustrate the provisions of §§301.9000-1 through 301.9000-5:

Example 1. A taxpayer sues a practitioner in state court for malpractice in connection with the practitioner’s preparation of a Federal income tax return. The taxpayer subpoenas an IRS employee to testify concerning the IRS employee’s examination of the taxpayer’s Federal income tax return. The taxpayer provides the statement required by §301.9000-5. This is a non-IRS matter. A testimony authorization would be required for the IRS employee to testify. (In addition, the taxpayer would be required to execute an appropriate consent under section 6103(c) of the Code). The IRS would oppose the IRS employee’s appearance in this case because the IRS is a disinterested party with respect to the dispute and would consider the commitment of resources to comply with the subpoena inappropriate.

Example 2. In a state judicial proceeding concerning child support, the child’s custodial parent subpoenas for a deposition an IRS agent who is examining certain post-divorce Federal income tax returns of the non-custodial parent. This is a non-IRS matter. The custodial parent submits with the subpoena the statement required by §301.9000-5 stating as the reason for the lack of taxpayer consent to disclosure that the non-custodial parent has refused to provide the consent (both a consent from the taxpayer complying with section 6103(c) and a testimony authorization would be required prior to the IRS agent testifying at the deposition). If taxpayer consent is obtained, the IRS may provide a declaration or certified return information of the taxpayer. A deposition would be unnecessary under the circumstances.

Example 3. The chairperson of a congressional committee requests the appearance of an IRS employee before the committee and committee staff to submit to questioning by committee staff concerning the procedures for processing Federal employment tax returns. This is an IRS congressional matter. Even though questioning would not involve the disclosure of returns or return information, the questioning would involve the disclosure of IRS records or information; therefore, a testimony authorization would be required. The IRS employee must contact the IRS Office of Legislative Affairs for instructions before appearing.

Example 4. The IRS opens a criminal investigation as to the tax liabilities of a taxpayer. This is an IRS matter. During the criminal investigation, the IRS refers the matter to the United States Department of Justice, requesting the institution of a Federal grand jury to investigate further potential criminal tax violations. The United States Department of Justice approves the request and initiates a grand jury investigation. The grand jury indicts the taxpayer. During the taxpayer’s trial, the taxpayer subpoenas an IRS special agent for testimony regarding the investigation. The records and information collected during the administrative stage of the investigation, including the taxpayer’s tax returns from IRS files, are IRS records and information. A testimony authorization is required for the IRS special agent to testify regarding this information. However, no IRS testimony authorization is required regarding the information collected by the IRS special agent when the IRS special agent was acting under the direction and control of the United States Attorney’s Office in the Federal grand jury investigation. That information is not IRS records or information within the meaning of §301.9000-1(a). Disclosure of that information should be coordinated with the United States Attorney’s Office.

Example 5. The United States Department of Justice attorney representing the IRS in a suit for refund requests testimony from an IRS revenue agent. This is an IRS matter. A testimony authorization would not be required for the IRS revenue agent to testify because the testimony was requested by the government attorney.

Example 6. In response to a request by the taxpayer’s counsel to interview an IRS revenue agent who was involved in a case at the administrative level, the United States Department of Justice attorney representing the IRS in a suit for refund asks that the IRS revenue agent be made available to be interviewed. This is an IRS matter. A testimony authorization would be required for the IRS revenue agent to testify because the testimony was first requested by taxpayer’s counsel.

Example 7. A state assistant attorney general, acting in accordance with a recommendation from his state’s department of revenue, is prosecuting a taxpayer under a state criminal law proscribing the intentional failure to file a state income tax return. The assistant attorney general serves an IRS employee with a subpoena to testify concerning the taxpayer’s Federal income tax return filing history. This is a non-IRS matter. This is also a state judicial proceeding pertaining to tax administration within the meaning of section 6103(h)(4) and (b)(4). As such, the requirements of section 6103(h)(4) apply. A testimony authorization would be required for the testimony demand in the subpoena.

Example 8. A former IRS revenue agent is requested to testify in a divorce proceeding. The request seeks testimony explaining the meaning of entries appearing on one party’s transcript of account, which is already in the possession of the parties. This is a non-IRS matter. No testimony authorization is required because the testimony requested from the former IRS employee involves general knowledge gained while the former IRS revenue agent was employed with the IRS.

Example 9. A Department of Justice attorney requests an IRS employee to testify in a refund suit involving Taxpayer A. The testimony may include tax convention information, as defined in section 6105, which was originally obtained by the IRS from a treaty partner in connection with a tax case against Taxpayer B. While no testimony authorization is necessary, because the testimony is being requested by government counsel in a tax matter, the IRS employee may not testify (or otherwise disclose IRS records or information) without coordinating with the U.S. Competent Authority, as disclosure of tax convention information is governed by section 6105. The disclosure must also meet the requirements in section 6103(h)(4).

Example 10. In a state court tort action, Defendant subpoenas IRS for Plaintiff’s federal income tax returns for particular taxable years. This is a non-IRS matter. The Disclosure Officer instructs Defendant that the IRS has established procedures for obtaining copies of Federal income tax returns. Section 601.702(d)(1) of this chapter establishes the procedures for obtaining Federal tax returns by requiring written requests for copies of tax returns using IRS Form 4506, “Request for Copy of Tax Return.” At Defendant’s request, Plaintiff executes Form 4506, naming Defendant’s counsel as designee, and the form is properly submitted to IRS. A testimony authorization would not be required to disclose Plaintiff’s returns to Defendant’s counsel.

These regulations are applicable on February 14, 2005.

* * * * *

(b) * * *

Approved February 3, 2005.

* * * * *

(b) Purpose. * * * Notwithstanding the requirements of this paragraph (b), for transactions occurring on or after February 25, 2005, a continuity of the business enterprise and a continuity of interest are not required for the transaction to qualify as a reorganization under section 368(a)(1)(E) or (F). * * *

* * * * *

Approved February 14, 2005.

* * * * *

(b) Adjustment to net unrealized built-in gain — (1) In general. If section 1374(d)(8) applies to an S corporation’s acquisition of assets, some or all of the stock of the corporation from which such assets were acquired was taken into account in the computation of the net unrealized built-in gain for a pool of assets of the S corporation, and some or all of such stock is redeemed or canceled in such transaction, then, subject to the limitations of paragraph (b)(2) of this section, such net unrealized built-in gain is adjusted to eliminate any effect that any built-in gain or built-in loss in the redeemed or canceled stock (other than stock with respect to which a loss under section 165 is claimed) had on the initial computation of net unrealized built-in gain for that pool of assets. For purposes of this paragraph, stock described in section 1374(d)(6) shall be treated as taken into account in the computation of the net unrealized built-in gain for a pool of assets of the S corporation.

(2) Limitations on adjustment — (i) Recognized built-in gain or loss. Net unrealized built-in gain for a pool of assets of the S corporation is only adjusted under paragraph (b)(1) of this section to reflect built-in gain or built-in loss in the redeemed or canceled stock that has not resulted in recognized built-in gain or recognized built-in loss during the recognition period.

(ii) Anti-duplication rule. Paragraph (b)(1) of this section shall not be applied to duplicate an adjustment to the net unrealized built-in gain for a pool of assets made pursuant to paragraph (b)(1) of this section.

(3) Effect of adjustment. Any adjustment to the net unrealized built-in gain made pursuant to this paragraph (b) only affects computations of the amount subject to tax under section 1374 for taxable years that end on or after the date of the acquisition to which section 1374(d)(8) applies.

(4) Pool of assets. For purposes of this section, a pool of assets means —

(i) The assets held by the corporation on the first day it became an S corporation, if the corporation was previously a C corporation; or

(ii) The assets the S corporation acquired from a C corporation in a section 1374(d)(8) transaction.

(c) Examples. The following examples illustrate the rules of this section:

Example 1. Computation of net unrealized built-in gain. (i)(A) X, a calendar year C corporation using the cash method, elects to become an S corporation on January 1, 1996. On December 31, 1995, X has assets and liabilities as follows:

(B) Further, X must include a total of $60,000 in taxable income in 1996, 1997, and 1998 under section 481(a).

(ii) If, on December 31, 1995, X sold all its assets to a third party that assumed all its liabilities, X’s amount realized would be $1,050,000 ($750,000 cash received + $300,000 liabilities assumed = $1,050,000). Thus, X’s net unrealized built-in gain is determined as follows:

Example 2. Adjustment to net unrealized built-in gain for built-in gain in eliminated C corporation stock. (i) X, a calendar year C corporation, elects to become an S corporation effective January 1, 2005. On that date, X’s assets (the first pool of assets) have a net unrealized built-in gain of $15,000. Among the assets in the first pool of assets is all of the outstanding stock of Y, a C corporation, with a fair market value of $33,000 and an adjusted basis of $18,000. On March 1, 2009, X sells an asset that it owned on January 1, 2005, and as a result has $10,000 of recognized built-in gain. X has had no other recognized built-in gain or built-in loss. X’s taxable income limitation for 2009 is $50,000. Effective June 1, 2009, X elects under section 1361 to treat Y as a qualified subchapter S subsidiary (QSub). The election is treated as a transfer of Y’s assets to X in a liquidation to which sections 332 and 337(a) apply.

(ii) Under paragraph (b) of this section, the net unrealized built in-gain of the first pool of assets is adjusted to account for the elimination of the Y stock in the liquidation. The net unrealized built-in gain of the first pool of assets, therefore, is decreased by $15,000, the amount by which the fair market value of the Y stock exceeded its adjusted basis as of January 1, 2005. Accordingly, for taxable years ending after June 1, 2009, the net unrealized built-in gain of the first pool of assets is $0.

(iii) Under §1.1374-2(a), X’s net recognized built-in gain for any taxable year equals the least of X’s pre-limitation amount, taxable income limitation, and net unrealized built-in gain limitation. In 2009, X’s pre-limitation amount is $10,000, X’s taxable income limitation is $50,000, and X’s net unrealized built-in gain limitation is $0. Because the net unrealized built-in gain of the first pool of assets has been adjusted to $0, despite the $10,000 of recognized built-in gain in 2009, X has $0 net recognized built-in gain for the taxable year ending on December 31, 2009.

Example 3. Adjustment to net unrealized built-in gain for built-in loss in eliminated C corporation stock. (i) X, a calendar year C corporation, elects to become an S corporation effective January 1, 2005. On that date, X’s assets (the first pool of assets) have a net unrealized built-in gain of negative $5,000. Among the assets in the first pool of assets is 10 percent of the outstanding stock of Y, a C corporation, with a fair market value of $18,000 and an adjusted basis of $33,000. On March 1, 2009, X sells an asset that it owned on January 1, 2005, resulting in $8,000 of recognized built-in gain. X has had no other recognized built-in gains or built-in losses. X’s taxable income limitation for 2009 is $50,000. On June 1, 2009, Y transfers its assets to X in a reorganization under section 368(a)(1)(C).

(ii) Under paragraph (b) of this section, the net unrealized built in-gain of the first pool of assets is adjusted to account for the elimination of the Y stock in the reorganization. The net unrealized built-in gain of the first pool of assets, therefore, is increased by $15,000, the amount by which the adjusted basis of the Y stock exceeded its fair market value as of January 1, 2005. Accordingly, for taxable years ending after June 1, 2009, the net unrealized built-in gain of the first pool of assets is $10,000.

(iii) Under §1.1374-2(a), X’s net recognized built-in gain for any taxable year equals the least of X’s pre-limitation amount, taxable income limitation, and net unrealized built-in gain limitation. In 2009, X’s pre-limitation amount is $8,000 and X’s taxable income limitation is $50,000. The net unrealized built-in gain of the first pool of assets has been adjusted to $10,000, so X’s net unrealized built-in gain limitation is $10,000. X, therefore, has $8,000 net recognized built-in gain for the taxable year ending on December 31, 2009. X’s net unrealized built-in gain limitation for 2010 is $2,000.

Example 4. Adjustment to net unrealized built-in gain in case of prior gain recognition. (i) X, a calendar year C corporation, elects to become an S corporation effective January 1, 2005. On that date, X’s assets (the first pool of assets) have a net unrealized built-in gain of $30,000. Among the assets in the first pool of assets is all of the outstanding stock of Y, a C corporation, with a fair market value of $45,000 and an adjusted basis of $10,000. Y has no current or accumulated earnings and profits. On April 1, 2007, Y distributes $18,000 to X, $8,000 of which is treated as gain to X from the sale or exchange of property under section 301(c)(3). That $8,000 is recognized built-in gain to X under section 1374(d)(3), and results in $8,000 of net recognized built-in gain to X for 2007. X’s net unrealized built-in gain limitation for 2008 is $22,000. On June 1, 2009, Y transfers its assets to X in a liquidation to which sections 332 and 337(a) apply.

(ii) Under paragraph (b) of this section, the net unrealized built in-gain of the first pool of assets is adjusted to account for the elimination of the Y stock in the liquidation. The net unrealized built-in gain of that pool of assets, however, can only be adjusted to reflect the amount of built-in gain that was inherent in the Y stock on January 1, 2005, that has not resulted in recognized built-in gain during the recognition period. In this case, therefore, the net unrealized built-in gain of the first pool of assets cannot be reduced by more than $27,000 ($35,000, the amount by which the fair market value of the Y stock exceeded its adjusted basis as of January 1, 2005, minus $8,000, the recognized built-in gain with respect to the stock during the recognition period). Accordingly, for taxable years ending after June 1, 2009, the net unrealized built-in gain of the first pool of assets is $3,000. The net unrealized built-in gain limitation for 2009 is $0.

Par. 3. Paragraph (a) of §1.1374-10 is revised to read as follows:

(a) In general. Sections 1.1374-1 through 1.1374-9, other than §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. Section 1.1374-3(b) and (c) Examples 2 through 4 apply to section 1374(d)(8) transactions that occur in taxable years beginning after February 23, 2005. In addition, an S corporation may apply §1.1374-3(b) and (c) Examples 2 through 4 to section 1374(d)(8) transactions that occur in taxable years beginning on or before February 23, 2005, if the S corporation (and any predecessors or successors) and all affected shareholders file original or amended returns that are consistent with these provisions for taxable years of the S corporation during the recognition period of the pool of assets the net unrealized built-in gain of which would be adjusted pursuant to those provisions that are not closed as of the first date after February 23, 2005, that the S corporation files an original or amended return. For purposes of this section, affected shareholders means all shareholders who received distributive shares of S corporation items in such taxable years. However, the Commissioner may, in appropriate circumstances, permit taxpayers to apply these provisions even if all affected shareholders cannot file consistent returns. In addition, for this purpose, a predecessor of an S corporation is a corporation that transfers its assets to the S corporation in a transaction to which section 381 applies. A successor of an S corporation is a corporation to which the S corporation transfers its assets in a transaction to which section 381 applies.

* * * * *

Approved February 14, 2005.

* * * * *

(a) * * *

(5) Holder.

* * * * *

* * * * *

(d) * * *

(2) Contingencies.

* * * * *

(6) Use of debt obligations to satisfy the annuity or unitrust payment obligation.

* * * * *

Par. 3. Section 25.2702-2 is amended as follows:

1. Paragraphs (a)(5) through (a)(9) are redesignated as paragraphs (a)(6) through (a)(10), respectively.

2. A new paragraph (a)(5) is added.

3. In newly designated paragraph (a)(6), the second sentence is removed and two sentences are added in its place.

4. In paragraph (d)(1), Example 6 and Example 7 are removed.

5. In paragraph (d)(2), introductory text, the language “Examples 8-10” is revised to read “Examples 6 through 8”.

6. In paragraph (d)(2), Examples 8, 9 and 10 are redesignated Examples 6, 7 and 8, respectively.

The additions read as follows:

(a) * * *

(5) Holder. The holder is the person to whom the annuity or unitrust interest is payable during the fixed term of that interest. References to holder shall also include the estate of that person.

(6) * * * If a transferor retains a power to revoke a qualified annuity interest or qualified unitrust interest of the transferor’s spouse, then the revocable qualified annuity or unitrust interest of the transferor’s spouse is treated as a retained qualified interest of the transferor. In order for the transferor to be treated as having retained a qualified interest under the preceding sentence, the interest of the transferor’s spouse (the successor holder) must be an interest that meets the requirements of a qualified annuity interest in accordance with §25.2702-3(b) and (d), or a qualified unitrust interest in accordance with §25.2702-3(c) and (d), but for the transferor’s retained power to revoke the interest. * * *

* * * * *

Par. 4. Section 25.2702-3 is amended as follows:

1. Paragraphs (d)(2) through (d)(5) are redesignated as paragraphs (d)(3) through (d)(6), respectively.

2. A new paragraph (d)(2) is added.

3. In newly designated paragraph (d)(4), the first two sentences are revised.

4. Newly designated paragraph (d)(5) is revised.

5. In paragraph (e), Example 5, the last sentence is revised.

6. In paragraph (e), Example 6, the last sentence is removed and two new sentences are added in its place.

7. In paragraph (e), new Example 8 and new Example 9 are added.

The revisions and additions read as follows:

* * * * *

(d) * * *

(2) Contingencies. A holder’s qualified interest must be payable in any event to or for the benefit of the holder for the fixed term of that interest. Thus, payment of the interest cannot be subject to any contingency other than either the survival of the holder until the commencement, or throughout the term, of that holder’s interest, or, in the case of a revocable interest described in §25.2702-2(a)(6), the transferor’s right to revoke the qualified interest of that transferor’s spouse.

* * * * *

(4) Term of the annuity or unitrust interest. The governing instrument must fix the term of the annuity or unitrust and the term of the interest must be fixed and ascertainable at the creation of the trust. The term must be for the life of the holder, for a specified term of years, or for the shorter (but not the longer) of those periods. * * *

(5) Commutation. The governing instrument must prohibit commutation (prepayment) of the interest of the holder.

* * * * *

(e) * * *

Example 5. * * * The interest of A (and A’s estate) to receive the unitrust amount for the specified term of 10 years in all events is a qualified unitrust interest for a term of 10 years.

Example 6. * * * As in Example 5, the interest of A (and A’s estate) to receive the unitrust amount for a specified term of 10 years in all events is a qualified unitrust interest for a term of 10 years. However, the right of A’s estate to continue to receive the unitrust amount after the expiration of the 10-year term if A dies within that 10-year period is not fixed and ascertainable at the creation of the interest and is not a qualified unitrust interest.

* * * * *

Example 8. A transfers property to an irrevocable trust, retaining the right to receive an annuity equal to 6 percent of the initial net fair market value of the trust property for 10 years, or until A’s prior death. At the expiration of the 10-year term, or on A’s death prior to the expiration of the 10-year term, the annuity is to be paid to B, A’s spouse, if then living, for 10 years or until B’s prior death. A retains an inter vivos and testamentary power to revoke B’s interest during the initial 10-year term. If not exercised by A during the initial 10-year term (whether during A’s life or on A’s death), A’s right to revoke B’s interest will lapse upon either A’s death during the 10-year term, or the expiration of A’s 10-year term (assuming A survives the term). Upon expiration of B’s interest (or on the expiration of A’s interest if A revokes B’s interest or if B predeceases A), the trust terminates and the trust corpus is payable to A’s child. Because A has made a completed gift of the remainder interest, the transfer of property to the trust is not incomplete as to all interests in the property and section 2702 applies. A’s annuity interest (A’s right to receive the annuity for 10 years, or until A’s prior death) is a retained interest that is a qualified annuity interest under paragraphs (b) and (d) of this section. In addition, because A has retained the power to revoke B’s interest, B’s interest is treated as an interest retained by A for purposes of section 2702. B’s successive annuity interest otherwise satisfies the requirements for a qualified interest contained in paragraph (d) of this section, but for A’s power to revoke. The term of B’s interest is specified in the governing instrument and is fixed and ascertainable at the creation of the trust, and B’s right to receive the annuity is contingent only on B’s survival, and A’s power to revoke. Following the expiration of A’s interest, the annuity is to be paid for a 10-year term or for B’s (the successor holder’s) life, whichever is shorter. Accordingly, A is treated as retaining B’s revocable qualified annuity interest pursuant to §25.2702-2(a)(6). Because both A’s interest and B’s interest are treated as qualified interests retained by A, the value of the gift is the value of the property transferred to the trust less the value of both A’s qualified interest and B’s qualified interest (subject to A’s power to revoke), each valued as a single-life annuity. If A survives the 10-year term without having revoked B’s interest, then A’s power to revoke lapses and A will make a completed gift to B at that time. Further, if A revokes B’s interest prior to the commencement of that interest, A is treated as making an additional completed gift at that time to A’s child. In either case, the amount of the gift would be the present value of B’s interest determined under section 7520 and the applicable regulations, as of the date the revocation power lapses or the interest is revoked. See §25.2511-2(f).

Example 9. (i) A transfers property to an irrevocable trust, retaining the right to receive 6 percent of the initial net fair market value of the trust property for 10 years, or until A’s prior death. If A survives the 10-year term, the trust terminates and the trust corpus is payable to A’s child. If A dies prior to the expiration of the 10-year term, the annuity is payable to B, A’s spouse, if then living, for the balance of the 10-year term, or until B’s prior death. A retains the right to revoke B’s interest. Upon expiration of B’s interest (or upon A’s death if A revokes B’s interest or if B predeceases A), the trust terminates and the trust corpus is payable to A’s child. As is the case in Example 8, A’s retained annuity interest (A’s right to receive the annuity for 10 years, or until A’s prior death) is a qualified annuity interest under paragraphs (b) and (d) of this section. However, B’s interest does not meet the requirements of paragraph (d) of this section. The term of B’s annuity is not fixed and ascertainable at the creation of the trust, because it is not payable for the life of B, a specified term of years, or for the shorter of those periods. Rather, B’s annuity is payable for an unspecified period that will depend upon the number of years left in the original term after A’s death. Further, B’s annuity is payable only if A dies prior to the expiration of the 10-year term. Thus, payment of B’s annuity is not dependent solely on B’s survival, but rather is dependent on A’s failure to survive.

(ii) Accordingly, the amount of the gift is the fair market value of the property transferred to the trust reduced by the value of A’s qualified interest (A’s right to receive the stated annuity for 10 years or until A’s prior death). B’s interest is not a qualified interest and is thus valued at zero under section 2702.

* * * * *

Par. 5. Section 25.2702-7 is amended by adding two sentences at the end of the section to read as follows:

* * * Section 25.2702-2(a)(5), the second and third sentences of §25.2702-2(a)(6), §25.2702-3(d)(2), the first two sentences of §25.2702-3(d)(4), the last sentence of §25.2702-3(e), Example 5, the last two sentences of §25.2702-3(e), Example 6, and §25.2702-3(e), Examples 8 and 9, apply for trusts created on or after July 26, 2004. However, the Internal Revenue Service will not challenge any prior application of the changes to Examples 5 and 6 in §25.2702-3(e).

Approved February 15, 2005.

Section 332(a) provides that no gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation. Section 332(b) provides, in part, that a distribution shall be considered to be in complete liquidation only if the corporation receiving such property was, on the date of the adoption of the plan of liquidation and at all times thereafter until the receipt of the property, the owner of stock that meets the requirements of section 1504(a)(2) and the distribution is made in complete cancellation or redemption of all of the stock of the liquidating corporation. Section 1.1502-34 provides that in determining the stock ownership of a member of a group in another corporation for purposes of determining the application of section 332(b), stock owned by all of the members of the group in that other corporation shall be aggregated. Therefore, for example, if one member of a group owns 60 percent of the stock of the liquidating corporation and another member of the group owns the remaining 40 percent of the stock of the liquidating corporation, section 332 will apply to the liquidation.

Section 337(a) provides that the liquidating corporation does not recognize gain or loss on the distribution to the 80-percent distributee of any property in a complete liquidation to which section 332 applies. For this purpose, the term “80-percent distributee” means only the corporation that meets the 80-percent stock ownership requirements of section 332(b). Under section 337(c), the determination of whether any corporation is an 80-percent distributee must be made without regard to any consolidated return regulation. Under section 336, if section 337(a) does not apply, the liquidating corporation must recognize gain or loss on the distribution of property in complete liquidation as if such property were sold to the distributee at its fair market value. Therefore, a liquidating distribution may be taxable to the distributing corporation and tax-free to the distributees.

Section 1.1502-13 prescribes rules for taking into account items of income, gain, deduction, and loss of members from intercompany transactions. The purpose of those rules is to clearly reflect the taxable income (and tax liability) of the group by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income or consolidated tax liability. Under §1.1502-13(j)(2)(ii), if the assets of a member of the group are acquired by a successor member, the successor member succeeds to, and takes into account (under the rules of §1.1502-13), the predecessor’s intercompany items. In addition, if two or more successor members acquire assets of the predecessor, the successors take into account the predecessor’s intercompany items in a manner that is consistently applied and reasonably carries out the purposes of §1.1502-13 and applicable provisions of law. Section 1.1502-13(j)(2)(i) provides that any reference to a person includes, as the context may require, a reference to a predecessor or successor. For this purpose, a predecessor includes a transferor of assets to a transferee (the successor) in a transaction (A) to which section 381(a) applies; (B) in which substantially all of the assets of the transferor are transferred to members in a complete liquidation; or (C) in which the successor’s basis in assets is determined (directly or indirectly, in whole or in part) by reference to the basis of the transferor, but the transferee is a successor only with respect to the assets the basis of which is so determined.

The current regulations include two examples that illustrate how these rules operate when a member of a group, X, engages in a complete liquidation in which it distributes its assets to S and B, also group members. In example 6 of §1.1502-13(j)(9), S owns 100 percent of the common stock of X and, therefore, is an 80-percent distributee without regard to the application of §1.1502-34. B owns 100 percent of the preferred stock of X, which is described in section 1504(a)(4), and, therefore, is an 80-percent distributee only by reason of the application of §1.1502-34. X recognizes gain on the assets distributed to B. That gain, however, is not taken into account as a result of the liquidation and S succeeds to that gain.

In example 7 of §1.1502-13(j)(9), S owns 60 percent of the X stock and B owns 40 percent of the X stock. Therefore, both S and B are 80-percent distributees only by reason of the application of §1.1502-34. X recognizes gain on the assets distributed to both S and B. That gain, however, is not taken into account as a result of the liquidation and S succeeds to X’s gain on the assets distributed to B and B succeeds to X’s gain on the assets distributed to S. As a result, under the acceleration rule, on the deconsolidation of either S or B, those gains would be taken into account in their entirety.

The rules illustrated by the examples reflect the concern that, under prior intercompany regulations, the assets of an acquired corporation could be broken up without a corporate level tax. See 59 FR 18011 (CO-11-91, 1994-1 C.B. 724). The IRS and Treasury Department have re-examined the current regulations and have concluded that accelerating all of the intercompany gains recognized on the liquidation of the liquidating corporation’s assets in these cases is not necessary to deter mirror subsidiary transactions. Therefore, these regulations propose that each member of the group to which assets of a liquidating member are transferred succeeds to, and takes into account, the intercompany items of the liquidating member that are generated in the liquidation to the extent such items would have been reflected in investment basis adjustments to the stock of the liquidating member owned by such distributee member under the principles of §1.1502-32(c) if, immediately prior to the liquidation, any stock of the liquidating member owned by nonmembers had been redeemed by the liquidating member in exchange for the money or property distributed to that nonmember in the liquidating distribution, and then such items had been taken into account under §1.1502-13(d).

These proposed regulations also address the manner in which the distributee members succeed to the intercompany items of the liquidating member that were not generated in the liquidating transaction. The IRS and Treasury Department have not identified a policy reason to distinguish between intercompany items that are generated in the liquidating transaction and intercompany items that are generated prior to the liquidating transaction. Therefore, these proposed regulations adopt the same rule for both of these categories of intercompany items.

Section 381(a)(1) provides that the acquiring corporation in a distribution to which section 332 applies shall succeed to, and take into account, the items of the distributor corporation (i.e., liquidating corporation) that are listed in section 381(c). Section 1.381(a)-1(b)(2) provides that only a single corporation can be an acquiring corporation for purposes of section 381. Currently, there are no rules that govern which corporation succeeds to the items of the liquidating corporation when section 332 applies to more than one distributee as may happen by reason of the application of §1.1502-34 when the distributees are members of the same consolidated group. These proposed regulations include such rules.

The IRS and Treasury Department believe that it is appropriate for each distributee member, even if it is not an 80-percent distributee without regard to the application of §1.1502-34, to succeed to items of the liquidating corporation that could be used to offset the income or tax liability of the group or any member. If the liquidating corporation is a member of the group, any income or gain recognized by the liquidating corporation in connection with the liquidation will be deferred under §1.1502-13. If §1.1502-13 did not apply, that income or gain could be offset by net operating losses of the liquidating corporation or, alternatively, any tax liability resulting from the recognition of that income or gain could be offset by credits of the liquidating corporation. The operation of §1.1502-34 should not change that result. Single entity principles should control in situations in which section 332 applies to the distributee members. Therefore, these proposed regulations provide that each distributee member succeeds to the items of the liquidating corporation that could be used to offset the income or tax liability of the group or any member (including net operating loss carryovers and capital loss carryovers) to the extent that such items would have been reflected in investment basis adjustments to the stock of the liquidating corporation owned by such distributee member under the principles of §1.1502-32(c) if, immediately prior to the liquidation, any stock of the liquidating corporation owned by nonmembers had been redeemed and then such items had been taken into account. In addition, each distributee member succeeds to the credits of the liquidating corporation (including credits under sections 38 and 53) to the extent that the items of gain, income, loss, or deduction attributable to the activities that gave rise to the credit would have been reflected in investment basis adjustments to the stock of the liquidating corporation owned by such distributee member under the principles of §1.1502-32(c) if, immediately prior to the liquidation, any stock of the liquidating corporation owned by nonmembers had been redeemed and then such items had been taken into account. For this purpose, if the liquidating corporation is not a member of the group at the time of the liquidation, these rules are applied as if the liquidating corporation had been a member of the group at that time. Finally, except to the extent that the distributee member’s earnings and profits already reflect the liquidating corporation’s earnings and profits, these proposed regulations provide that the earnings and profits of the liquidating corporation are allocated to each distributee member under the principles of §1.1502-32(c), treating any stock of the liquidating corporation owned by nonmembers as if it had been redeemed immediately prior to the liquidation.

With respect to items other than those that can offset the income or tax liability of the group or any member and earnings and profits, these proposed regulations provide that a distributee member that, immediately prior to the liquidation, satisfies the requirements of section 1504(a)(2) without regard to §1.1502-34 succeeds to the items of the liquidating corporation in accordance with the principles set forth in the Code (including section 381) and the regulations promulgated thereunder. This rule is consistent with the treatment of a nonconsolidated corporation that satisfies the ownership requirements of section 1504(a)(2) with respect to a liquidating corporation.

Finally, again with respect to items other than those that can offset the income or tax liability of the group or any member and earnings and profits, these proposed regulations provide that a distributee member that, immediately prior to the liquidation, does not own stock in the liquidating corporation meeting the requirements of section 1504(a)(2) without regard to §1.1502-34 succeeds to items of the liquidating corporation to the extent that it would have succeeded to those items if it had purchased, in a taxable transaction, the assets or businesses of the liquidating corporation that it received in the liquidation and assumed the liabilities it assumed in the liquidation. As described above, pursuant to section 336, to the extent that section 337(a) does not apply, a liquidating corporation must recognize gain or loss on the distribution of property in complete liquidation as if such property were sold to the distributee at its fair market value. Although no provision of the Code states that the distributee is the purchaser of those assets, the IRS and Treasury Department believe that it is reasonable to treat the distributee as purchasing those assets for purposes of determining the attributes to which such a distributee succeeds.

* * * * *

(j) * * *

(2) * * *

(ii) Intercompany items. * * * For example, if the assets of a predecessor are acquired by more than one successor in a transaction to which section 381(a)(1) applies, each successor succeeds to, and takes into account (under the rules of this section), each of the predecessor’s intercompany items (whether resulting from distributions in liquidation or otherwise) to the extent that such items would have been reflected in investment basis adjustments to the stock of the predecessor owned by that successor under the principles of §1.1502-32(c) if, immediately prior to the liquidation, any stock of the predecessor owned by nonmembers had been redeemed in exchange for the money or property distributed to that nonmember in the transaction to which section 381(a)(1) applies, and then such items had been taken into account under §1.1502-13(d).

(iii) Effective date. The third sentence of paragraph (j)(2)(ii) of this section applies to transactions occurring after the date these regulations are published as final regulations in the Federal Register.

* * * * *

(9) Examples. (i) The operating rules of this paragraph (j) are illustrated generally throughout this section, and by the following examples:

* * * * *

Example 6. Liquidation—80% distributee. (i) Facts. B1, B2, and S are members of the same consolidated group. S has only common stock outstanding. B1 owns 80% of S’s stock, and B2 owns the remaining 20%. On January 1 of Year 2, S sells two assets to another member of the group. S recognizes $100 of gain with respect to the first asset and $100 of loss with respect to the second asset. On July 1 of Year 3, S distributes all of its remaining assets to B1 and B2 in a complete liquidation. At the time of the liquidation, S’s assets have an aggregate basis of $0 and an aggregate value of $100, and neither the gain nor the loss from the prior two asset sales has been taken into account under this section. Under §1.1502-34, section 332 applies to both B1 and B2. Under section 337, S has no gain or loss from its liquidating distribution to B1. Under sections 336 and 337(c), S has a $20 gain from its liquidating distribution to B2. On January 1 of Year 4, B2 ceases to be a member of the group.

(ii) Succession to intercompany items. Under the matching rule, S’s $20 gain from its liquidating distribution to B2 is not taken into account under this section as a result of the liquidation (and, therefore, is not yet reflected under §§1.1502-32 and 1.1502-33). Under the successor person rule of paragraph (j)(2)(i) of this section, B1 and B2 are both successors to S. Under paragraph (j)(2)(ii) of this section, B1 and B2 each succeeds to S’s intercompany items to the extent that such items would have been reflected in investment basis adjustments to its stock of S under the principles of §1.1502-32(c) if, immediately prior to the liquidation, such items had been taken into account under §1.1502-13(d). Therefore, B1 succeeds to 80% of the $20 of intercompany gain from the assets distributed to B2 in the liquidation, and 80% of the $100 of intercompany gain and 80% of the $100 of intercompany loss from the assets that S sold prior to the liquidation. In addition, B2 succeeds to 20% of the $20 of intercompany gain from the assets distributed to B2 in the liquidation and 20% of the $100 of intercompany gain and 20% of the $100 of intercompany loss from the assets that S sold prior to the liquidation.

(iii) Taking into account intercompany items. S’s gain from its liquidating distribution to B2 and S’s gain and loss from the sale of the two assets prior to the liquidation will be taken into account by B1 and B2 under the matching and acceleration rules of this section based on subsequent events. Therefore, in connection with B2 ceasing to be a member of the group, B1 will take into account $16 of the intercompany gain from the assets distributed to B2 in the liquidation. In addition, B2 will take into account $4 of the intercompany gain from the assets distributed to B2 in the liquidation and $20 of the intercompany gain and $20 of the intercompany loss from the two assets that S sold prior to the liquidation.

Example 7. Liquidation—no 80% distributee. (i) Facts. B1, B2, and S are members of the same consolidated group. S has only common stock outstanding. B1 and B2 each owns 40% of S’s stock, and A, a nonmember, owns the remaining 20% of S’s stock. On January 1 of Year 2, S sells two assets to another member of the group. S recognizes $100 of gain with respect to the first asset and $100 of loss with respect to the second asset. On July 1 of Year 3, S distributes all of its remaining assets to B1, B2, and A in complete liquidation. At the time of the liquidation, S’s assets have an aggregate basis of $0 and an aggregate value of $100, and neither the gain nor the loss from the prior two asset sales has been taken into account under this section. Under §1.1502-34, section 332 applies to both B1 and B2. Under sections 336 and 337(c), S has a $100 gain from its liquidating distributions to B1, B2, and A.

(ii) Succession to intercompany items. Under the matching rule, S’s $80 gain from its liquidating distributions to B1 and B2 is not taken into account under this section as a result of the liquidation (and, therefore, is not yet reflected under §§1.1502-32 and 1.1502-33). Under the successor person rule of paragraph (j)(2)(i) of this section, B1 and B2 are successors to S. Under paragraph (j)(2)(ii) of this section, B1 and B2 each succeeds to S’s intercompany items to the extent that such items would have been reflected in investment basis adjustments to its stock of S under the principles of §1.1502-32(c) if, immediately prior to the liquidation, the stock of S owned by A had been redeemed in exchange for the money or property distributed to A in the liquidation, and then such items had been taken into account under §1.1502-13(d). If A had been redeemed, then S’s items would have produced investment basis adjustments in the stock of S owned by each of B1 and B2 equally. Therefore, each of B1 and B2 succeeds to 50% of the $80 of intercompany gain from the assets distributed to B1 and B2 in the liquidation and 50% of the $100 of intercompany gain and 50% of the $100 of intercompany loss from the assets that S sold prior to the liquidation. S’s $20 gain with respect to the assets that are distributed to A in the liquidation is taken into account immediately.

(iii) Taking into account intercompany items. S’s gain from its liquidating distributions to B1 and B2 and S’s gain and loss from the sale of the two assets prior to the liquidation will be taken into account by B1 and B2 under the matching and acceleration rules of this section based on subsequent events.

(ii) Effective dates. Paragraph (j)(9)(i) Examples 6 and 7 apply to transactions occurring after the date these regulations are published as final regulations in the Federal Register.

* * * * *

Par. 3. Section 1.1502-80 is amended by:

1. Removing the second sentence from §1.1502-80(a).

2. Adding paragraph (g).

The addition reads as follows:

* * * * *

(g) Special rules for liquidations to which section 332 applies. Notwithstanding the general rule of section 381, if one or more members is a distributee of assets in a liquidation to which section 332 applies and such member or members in the aggregate own stock of the liquidating corporation that satisfies the requirements of section 1504(a)(2) (regardless of whether any single member owns stock in the liquidating corporation that satisfies the requirements of section 1504(a)(2)), such member or members shall succeed to the items (including items described in section 381(c)) of the liquidating corporation, to the extent not otherwise prohibited by any applicable provision of law, as provided in this paragraph (g).

(1) Each distributee member shall succeed to the items of the liquidating corporation that could be used to offset the income or tax liability of the group or any member (including net operating loss carryovers and capital loss carryovers) to the extent that such items would have been reflected in investment basis adjustments to the stock of the liquidating corporation owned by such distributee member under the principles of §1.1502-32(c) if, immediately prior to the liquidation, any stock of the liquidating corporation owned by nonmembers had been redeemed and then such items had been taken into account. In addition, each distributee member shall succeed to the credits of the liquidating corporation (including credits under sections 38 and 53) to the extent that the items of gain, income, loss, or deduction attributable to the activities that gave rise to the credit would have been reflected in investment basis adjustments to the stock of the liquidating corporation owned by such distributee member under the principles of §1.1502-32(c) if, immediately prior to the liquidation, any stock of the liquidating corporation owned by nonmembers had been redeemed and then such items had been taken into account. If the liquidating corporation is not a member of the group at the time of the liquidation, the previous two sentences shall be applied as if the liquidating corporation had been a member of the group at the time of the liquidation. Finally, except to the extent that the distributee member’s earnings and profits already reflect the liquidating corporation’s earnings and profits, the earnings and profits of the liquidating corporation are allocated to each distributee member under the principles of §1.1502-32(c), treating any stock of the liquidating corporation owned by nonmembers as if it had been redeemed immediately prior to the liquidation.

(2) With regard to items to which paragraph (g)(1) of this section does not apply, a distributee member that, immediately prior to the liquidation, owns stock in the liquidating corporation meeting the requirements of section 1504(a)(2) without regard to §1.1502-34 shall succeed to items of the liquidating corporation in accordance with section 381 and other applicable principles.

(3) With regard to items to which paragraph (g)(1) of this section does not apply, a distributee member that, immediately prior to the liquidation, does not own stock in the liquidating corporation meeting the requirements of section 1504(a)(2) without regard to §1.1502-34 shall succeed to items of the liquidating corporation to the extent that it would have succeeded to those items if it had purchased, in a taxable transaction, the assets or businesses of the liquidating corporation that it received in the liquidation and assumed the liabilities it assumed in the liquidation.

(4) Examples. The following examples illustrate the application of this paragraph (g):

Example 1. Liquidation—80% distributee. (i) Facts. X has only common stock outstanding. On January 1 of Year 1, X acquired equipment with a 10-year life and elected to depreciate the equipment using the straight-line method of depreciation. On January 1 of Year 7, B1 and B2 own 80% and 20%, respectively, of X’s stock. X is a domestic corporation but is not a member of the group that includes B1 and B2. On that date, X distributes all of its assets to B1 and B2 in complete liquidation. The equipment is distributed to B1. Under section 334(b), B1’s basis in the equipment is the same as it would be in X’s hands. After computing its tax liability for the taxable year that includes the liquidation, X has net operating losses of $100, business credits of $40, and earnings and profits of $80.

(ii) Succession to items described in section 381(c). Under paragraph (g)(1) of this section, B1 and B2 each succeeds to X’s items that could be used to offset the income or tax liability of the group or any member to the extent that such items would have been reflected in investment basis adjustments to the stock of X it owned under the principles of §1.1502-32(c) if, immediately prior to the liquidation, such items had been taken into account. Accordingly, B1 and B2 succeed to $80 and $20, respectively, of X’s net operating loss. In addition, under paragraph (g)(1) of this section, because, immediately prior to the liquidation, 80% of the items of gain, income, loss, or deduction attributable to the activities that gave rise to the business credits of $40 would have been reflected in investment basis adjustments to the stock of X owned by B1 under the principles of §1.1502-32(c) and 20% of those items would have been reflected in investment basis adjustments to the stock of X owned by B2 under those same principles, B1 and B2 succeed to $32 and $8, respectively, of X’s business credits. Under paragraph (g)(1) of this section, because B1’s and B2’s earnings and profits do not reflect X’s earnings and profits, X’s earnings and profits are allocated to B1 and B2 under the principles of §1.1502-32(c). Therefore, B1 and B2 succeed to $64 and $16, respectively, of X’s earnings and profits. Finally, because B1 owns stock in X meeting the requirements of section 1504(a)(2) without regard to §1.1502-34, under paragraph (g)(2), B1 is required to continue to depreciate the equipment using the straight-line method of depreciation.

Example 2. Liquidation—no 80% distributee. (i) Facts. The facts are the same as in Example 1 except that B1 and B2 own 60% and 40%, respectively, of X’s stock. Therefore, under section 334(a), B1’s basis in the equipment is its fair market value at the time of the distribution. In addition, on January 1 of Year 6, X entered into a long-term contract with Y, an unrelated party. The total contract price is $1000, and X estimates the total allocable contract costs to be $500. At the time of the liquidation, X had received $250 in progress payments under the contract and incurred costs of $125. X accounted for the contract under the percentage of completion method described in section 460(b). In the liquidation, B1 assumes X’s contract obligations and rights.

(ii) Succession to items described in section 381(c). (A) Losses and credits. Under paragraph (g)(1) of this section, B1 and B2 each succeeds to X’s items that could be used to offset the income or tax liability of the group or any member to the extent that such items would have been reflected in investment basis adjustments to the stock of X it owned under the principles of §1.1502-32(c) if, immediately prior to the liquidation, such items had been taken account. Accordingly, B1 and B2 succeed to $60 and $40, respectively, of X’s net operating loss. In addition, under paragraph (g)(1) of this section, because, immediately prior to the liquidation 60% of the items of gain, income, loss, or deduction attributable to the activities that gave rise to the business credits of $40 would have been reflected in investment basis adjustments to the stock of X owned by B1 under the principles of §1.1502-32(c) and 40% of those items would have been reflected in the investment basis adjustments to the stock of X owned by B2 under those same principles, B1 and B2 succeed to $24 and $16, respectively, of X’s business credits.

(B) Earnings and profits. Under paragraph (g)(1) of this section, because B1’s and B2’s earnings and profits do not reflect X’s earnings and profits, X’s earnings and profits are allocated to B1 and B2 under the principles of §1.1502-32(c). Therefore, B1 and B2 succeed to $48 and $32, respectively, of X’s earnings and profits.

(C) Depreciation of equipment’s basis. By reason of section 168(i)(7), to the extent that B1’s basis in the equipment does not exceed X’s basis in the equipment, B1 will be required to continue to depreciate the equipment using the straight-line method of depreciation.

(D) Method of accounting for long-term contract. Under paragraph (g)(3) of this section, B1 does not succeed to X’s method of accounting for the contract. Rather, under §1.460-4(k)(2), B1 is treated as having entered into a new contract on the date of the liquidation. Under §1.460-4(k)(2)(iii), B1 must evaluate whether the new contract should be classified as a long-term contract within the meaning of §1.460-1(b) and account for the contract under a permissible method of accounting.

(5) Effective date. Paragraph (g) applies to transactions occurring after the date these regulations are published as final regulations in the Federal Register.

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