Under section 121(a), a taxpayer may exclude up to $250,000 ($500,000 for certain joint returns) of gain realized on the sale or exchange of the taxpayer’s principal residence if the taxpayer owned and used the property as the taxpayer’s principal residence for at least two years during the five-year period ending on the date of the sale or exchange. Section 121(b)(3) allows the taxpayer to apply the maximum exclusion to only one sale or exchange during the two-year period ending on the date of the sale or exchange. Section 121(c) provides that a taxpayer who fails to meet any of the conditions by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances, may be entitled to an exclusion in a reduced maximum amount.

The temporary regulations provide, as a general definition, that a sale or exchange is by reason of a change in place of employment, health, or unforeseen circumstances only if the taxpayer’s primary reason for the sale or exchange is a change in place of employment, health, or unforeseen circumstances. The temporary regulations provide factors that may be relevant in determining the taxpayer’s primary reason for the sale or exchange.

One commentator asserted that the factors are beyond Congressional intent, unnecessary, and overbroad. The final regulations retain the list of factors because it is helpful in determining the taxpayer’s primary reason for the sale or exchange.

For each of the three grounds for claiming a reduced maximum exclusion, the temporary regulations provide a general definition and one or more safe harbors. Under the temporary regulations, if a safe harbor applies, the taxpayer’s “primary reason” for the sale or exchange is deemed to be change in place of employment, health, or unforeseen circumstances. For greater simplicity, the final regulations delete the primary reason test from the safe harbors and provide that, if a safe harbor applies, the sale or exchange is deemed to be “by reason of” a change in place of employment, health, or unforeseen circumstances. If a safe harbor does not apply, the taxpayer may be eligible to claim a reduced maximum exclusion if the taxpayer establishes, based on the facts and circumstances, that the taxpayer’s primary reason for the sale or exchange is a change in place of employment, health, or unforeseen circumstances.

The temporary regulations provide that a sale or exchange is by reason of unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer does not anticipate before purchasing and occupying the residence. One commentator asserted that this definition is beyond Congressional intent and would allow any circumstance giving rise to the sale or exchange of property to qualify for a reduced maximum exclusion.

The final regulations revise the definition of a sale or exchange by reason of unforeseen circumstances from “an event that the taxpayer did not anticipate” to “an event that the taxpayer could not reasonably have anticipated” before purchasing and occupying the residence. Additionally, the final regulations clarify that a sale or exchange by reason of unforeseen circumstances (other than a sale or exchange within a safe harbor) does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances. The final regulations provide additional examples illustrating the application of the reduced maximum exclusion rules to situations outside of the unforeseen circumstances safe harbors.

Under the temporary regulations, a taxpayer’s primary reason for the sale or exchange is deemed to be unforeseen circumstances if one of the following safe harbor events occurs during the taxpayer’s ownership and use of the property: (1) involuntary conversion of the residence, (2) a natural or man-made disaster or act of war or terrorism resulting in a casualty to the residence, and (3) in the case of a qualified individual, (a) death, (b) the cessation of employment as a result of which the individual is eligible for unemployment compensation, (c) a change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household, (d) divorce or legal separation under a decree of divorce or separate maintenance, (e) multiple births resulting from the same pregnancy, or (f) an event determined by the Commissioner to be an unforeseen circumstance. A taxpayer who does not qualify for a safe harbor may demonstrate that, under the facts and circumstances, the primary reason for the sale or exchange is unforeseen circumstances.

Commentators suggested that marriage, bankruptcy of the taxpayer’s employer not resulting in the loss of the taxpayer’s employment, and the adoption of a family member should be additional unforeseen circumstances safe harbors that qualify for the reduced maximum exclusion.

The final regulations do not adopt these comments. Marriage and adoption are voluntary events that typically lack the degree of unforeseeability common in the other unforeseen circumstances safe harbors, and bankruptcy of the taxpayer’s employer unaccompanied by a change in employment status of the taxpayer does not impact the taxpayer’s current ability to pay housing costs. However, these events may still qualify for the reduced maximum exclusion under the facts and circumstances test if, as a result of such an event, the taxpayer’s primary reason for the sale or exchange is a change in place of employment, health, or unforeseen circumstances.

For purposes of the reduced maximum exclusion by reason of unforeseen circumstances, the temporary regulations provide that a qualified individual includes the taxpayer, the taxpayer’s spouse, a co-owner of the residence, and a person whose principal place of abode is in the same household as the taxpayer.

A commentator suggested that the unforeseen circumstances exception should be limited to events involving only the taxpayer and the taxpayer’s spouse. The commentator stated that, under this narrower exception, a safe harbor for death would be unnecessary because little, if any, gain would result as a consequence of the step-up in basis provisions of the Code. The commentator also asserted that the safe harbor for involuntary conversions is redundant and unnecessary because section 1033 already provides for non-recognition of gain in such circumstances.

The final regulations do not adopt these comments. The inclusion in the safe harbors of events affecting co-owners and co-inhabitants is appropriate because these events may affect the taxpayer’s ability to pay housing costs. The involuntary conversion safe harbor is also appropriate, as both the non-recognition provisions of section 1033 and the exclusion provisions of section 121 may apply to a conversion of property. See section 121(d)(5).

The temporary regulations provide that unforeseen circumstances include events determined by the Commissioner to be unforeseen circumstances to the extent provided in published guidance of general applicability or in a ruling directed to a specific taxpayer. The final regulations clarify that taxpayers may rely on only those determinations made by the Commissioner in published guidance of general applicability. A ruling directed to a specific taxpayer does not establish a safe harbor of general applicability.

The temporary regulations provide that a sale or exchange of a residence is by reason of health if the primary reason for the sale or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. A sale or exchange that is merely beneficial to the general health or well-being of the individual is not a sale or exchange by reason of health. This definition is based on the definition of medical care under section 213.

A commentator suggested eliminating the term diagnosis from the definition of sale or exchange by reason of health because taxpayers rarely would sell a residence merely to obtain a diagnosis of a disease, illness, or injury. The final regulations do not adopt this suggestion because, while such sales are likely to be uncommon, they may occur. In addition, retaining diagnosis in the general definition of sale or exchange by reason of health maintains uniformity with the definition of medical care under section 213 and reduces complexity.

A commentator suggested that the regulations should clarify that, under section 6501, the statute of limitations on assessments arising from the use of the exclusion begins to run from the filing date for the year of the sale or exchange. The final regulations do not address this issue because the issue is well-settled by statute and rules regarding the statute of limitations on assessments are outside the scope of these regulations.

Numerous commentators suggested that members of the uniformed services should be accorded a special exception to the use requirement because they are often required to be away from home for extended periods of time and unable to use a property as their principal residence for at least two years during the five-year period prior to a sale or exchange. The final regulations reflect enactment of the Military Family Tax Relief Act of 2003 Public Law 108-121, section 101 (117 Stat. 1335) (MFTRA). The MFTRA amends section 121 to provide that a taxpayer serving (or whose spouse is serving) on qualified official extended duty as a member of the uniformed services or Foreign Service may elect to suspend the running of the 5-year period for up to 10 years. The election may be made with respect to only one property at a time.

The taxpayer makes an election by filing a return for the taxable year of the sale or exchange of the taxpayer’s principal residence that does not include the resulting gain in the taxpayer’s gross income. A taxpayer who would qualify to exclude gain under section 121 as a result of the amendments made by the MFTRA but is barred by operation of any law or rule of law may nonetheless claim a refund or credit of an overpayment of tax if the taxpayer files the claim before November 11, 2004.

Section 1.121-3 of the final regulations, relating to the reduced maximum exclusion, applies to sales and exchanges on or after August 13, 2004. For sales or exchanges before August 13, 2004, and on or after May 7, 1997, taxpayers may elect to apply the rules retroactively in accordance with §1.121-4(j) and will be afforded audit protection in accordance with §1.121-4(k). Section 1.121-5 of the final regulations, relating to the suspension of the 5-year period for certain members of the uniformed services and Foreign Service, applies to sales and exchanges on or after May 7, 1997.

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(b) Primary reason for sale or exchange. In order for a taxpayer to claim a reduced maximum exclusion under section 121(c), the sale or exchange must be by reason of a change in place of employment, health, or unforeseen circumstances. If a safe harbor described in this section applies, a sale or exchange is deemed to be by reason of a change in place of employment, health, or unforeseen circumstances. If a safe harbor described in this section does not apply, a sale or exchange is by reason of a change in place of employment, health, or unforeseen circumstances only if the primary reason for the sale or exchange is a change in place of employment (within the meaning of paragraph (c) of this section), health (within the meaning of paragraph (d) of this section), or unforeseen circumstances (within the meaning of paragraph (e) of this section). Whether the requirements of this section are satisfied depends upon all the facts and circumstances. Factors that may be relevant in determining the taxpayer’s primary reason for the sale or exchange include (but are not limited to) the extent to which—

(1) The sale or exchange and the circumstances giving rise to the sale or exchange are proximate in time;

(2) The suitability of the property as the taxpayer’s principal residence materially changes;

(3) The taxpayer’s financial ability to maintain the property is materially impaired;

(4) The taxpayer uses the property as the taxpayer’s residence during the period of the taxpayer’s ownership of the property;

(5) The circumstances giving rise to the sale or exchange are not reasonably foreseeable when the taxpayer begins using the property as the taxpayer’s principal residence; and

(6) The circumstances giving rise to the sale or exchange occur during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence.

(c) Sale or exchange by reason of a change in place of employment—(1) In general. A sale or exchange is by reason of a change in place of employment if, in the case of a qualified individual described in paragraph (f) of this section, the primary reason for the sale or exchange is a change in the location of the individual’s employment.

(2) Distance safe harbor. A sale or exchange is deemed to be by reason of a change in place of employment (within the meaning of paragraph (c)(1) of this section) if—

(i) The change in place of employment occurs during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence; and

(ii) The qualified individual’s new place of employment is at least 50 miles farther from the residence sold or exchanged than was the former place of employment, or, if there was no former place of employment, the distance between the qualified individual’s new place of employment and the residence sold or exchanged is at least 50 miles.

(3) Employment. For purposes of this paragraph (c), employment includes the commencement of employment with a new employer, the continuation of employment with the same employer, and the commencement or continuation of self-employment.

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

Example 1. A is unemployed and owns a townhouse that she has owned and used as her principal residence since 2003. In 2004 A obtains a job that is 54 miles from her townhouse, and she sells the townhouse. Because the distance between A’s new place of employment and the townhouse is at least 50 miles, the sale is within the safe harbor of paragraph (c)(2) of this section and A is entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 2. B is an officer in the United States Air Force stationed in Florida. B purchases a house in Florida in 2002. In May 2003, B moves out of his house to take a 3-year assignment in Germany. B sells his house in January 2004. Because B’s new place of employment in Germany is at least 50 miles farther from the residence sold than is B’s former place of employment in Florida, the sale is within the safe harbor of paragraph (c)(2) of this section and B is entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 3. C is employed by Employer R at R’s Philadelphia office. C purchases a house in February 2002 that is 35 miles from R’s Philadelphia office. In May 2003, C begins a temporary assignment at R’s Wilmington office that is 72 miles from C’s house, and moves out of the house. In June 2005, C is assigned to work in R’s London office. C sells her house in August 2005 as a result of the assignment to London. The sale of the house is not within the safe harbor of paragraph (c)(2) of this section by reason of the change in place of employment from Philadelphia to Wilmington because the Wilmington office is not 50 miles farther from C’s house than is the Philadelphia office. Furthermore, the sale is not within the safe harbor by reason of the change in place of employment to London because C is not using the house as her principal residence when she moves to London. However, C is entitled to claim a reduced maximum exclusion under section 121(c)(2) because, under the facts and circumstances, the primary reason for the sale is the change in C’s place of employment.

Example 4. In July 2003 D, who works as an emergency medicine physician, buys a condominium that is 5 miles from her place of employment and uses it as her principal residence. In February 2004, D obtains a job that is located 51 miles from D’s condominium. D may be called in to work unscheduled hours and, when called, must be able to arrive at work quickly. Because of the demands of the new job, D sells her condominium and buys a townhouse that is 4 miles from her new place of employment. Because D’s new place of employment is only 46 miles farther from the condominium than is D’s former place of employment, the sale is not within the safe harbor of paragraph (c)(2) of this section. However, D is entitled to claim a reduced maximum exclusion under section 121(c)(2) because, under the facts and circumstances, the primary reason for the sale is the change in D’s place of employment.

(d) Sale or exchange by reason of health—(1) In general. A sale or exchange is by reason of health if the primary reason for the sale or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual described in paragraph (f) of this section, or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. A sale or exchange that is merely beneficial to the general health or well-being of an individual is not a sale or exchange by reason of health.

(2) Physician’s recommendation safe harbor. A sale or exchange is deemed to be by reason of health if a physician (as defined in section 213(d)(4)) recommends a change of residence for reasons of health (as defined in paragraph (d)(1) of this section).

(3) Examples. The following examples illustrate the rules of this paragraph (d):

Example 1. In 2003, A buys a house that she uses as her principal residence. A is injured in an accident and is unable to care for herself. A sells her house in 2004 and moves in with her daughter so that the daughter can provide the care that A requires as a result of her injury. Because, under the facts and circumstances, the primary reason for the sale of A’s house is A’s health, A is entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 2. H’s father has a chronic disease. In 2003, H and W purchase a house that they use as their principal residence. In 2004, H and W sell their house in order to move into the house of H’s father so that they can provide the care he requires as a result of his disease. Because, under the facts and circumstances, the primary reason for the sale of their house is the health of H’s father, H and W are entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 3. H and W purchase a house in 2003 that they use as their principal residence. Their son suffers from a chronic illness that requires regular medical care. Later that year their son begins a new treatment that is available at a hospital 100 miles away from their residence. In 2004, H and W sell their house so that they can be closer to the hospital to facilitate their son’s treatment. Because, under the facts and circumstances, the primary reason for the sale is to facilitate the treatment of their son’s chronic illness, H and W are entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 4. B, who has chronic asthma, purchases a house in Minnesota in 2003 that he uses as his principal residence. B’s doctor tells B that moving to a warm, dry climate would mitigate B’s asthma symptoms. In 2004, B sells his house and moves to Arizona to relieve his asthma symptoms. The sale is within the safe harbor of paragraph (d)(2) of this section and B is entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 5. In 2003, H and W purchase a house in Michigan that they use as their principal residence. H’s doctor tells H that he should get more outdoor exercise, but H is not suffering from any disease that can be treated or mitigated by outdoor exercise. In 2004, H and W sell their house and move to Florida so that H can increase his general level of exercise by playing golf year-round. Because the sale of the house is merely beneficial to H’s general health, the sale of the house is not by reason of H’s health. H and W are not entitled to claim a reduced maximum exclusion under section 121(c)(2).

(e) Sale or exchange by reason of unforeseen circumstances—(1) In general. A sale or exchange is by reason of unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence. A sale or exchange by reason of unforeseen circumstances (other than a sale or exchange deemed to be by reason of unforeseen circumstances under paragraph (e)(2) or (3) of this section) does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances.

(2) Specific event safe harbors. A sale or exchange is deemed to be by reason of unforeseen circumstances (within the meaning of paragraph (e)(1) of this section) if any of the events specified in paragraphs (e)(2)(i) through (iii) of this section occur during the period of the taxpayer’s ownership and use of the residence as the taxpayer’s principal residence:

(i) The involuntary conversion of the residence.

(ii) Natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence (without regard to deductibility under section 165(h)).

(iii) In the case of a qualified individual described in paragraph (f) of this section—

(A) Death;

(B) The cessation of employment as a result of which the qualified individual is eligible for unemployment compensation (as defined in section 85(b));

(C) A change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household (including amounts for food, clothing, medical expenses, taxes, transportation, court-ordered payments, and expenses reasonably necessary to the production of income, but not for the maintenance of an affluent or luxurious standard of living);

(D) Divorce or legal separation under a decree of divorce or separate maintenance; or

(E) Multiple births resulting from the same pregnancy.

(3) Designation of additional events as unforeseen circumstances. The Commissioner may designate other events or situations as unforeseen circumstances in published guidance of general applicability and may issue rulings addressed to specific taxpayers identifying other events or situations as unforeseen circumstances with regard to those taxpayers (see §601.601(d)(2) of this chapter).

(4) Examples. The following examples illustrate the rules of this paragraph (e):

Example 1. In 2003, A buys a house in California. After A begins to use the house as her principal residence, an earthquake causes damage to A’s house. A sells the house in 2004. The sale is within the safe harbor of paragraph (e)(2)(ii) of this section and A is entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 2. H works as a teacher and W works as a pilot. In 2003, H and W buy a house that they use as their principal residence. Later that year W is furloughed from her job for six months. H and W are unable to pay their mortgage and reasonable basic living expenses for their household during the period W is furloughed. H and W sell their house in 2004. The sale is within the safe harbor of paragraph (e)(2)(iii)(C) of this section and H and W are entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 3. In 2003, H and W buy a two-bedroom condominium that they use as their principal residence. In 2004, W gives birth to twins and H and W sell their condominium and buy a four-bedroom house. The sale is within the safe harbor of paragraph (e)(2)(iii)(E) of this section, and H and W are entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 4. In 2003, B buys a condominium in a high-rise building and uses it as his principal residence. B’s monthly condominium fee is $X. Three months after B moves into the condominium, the condominium association replaces the building’s roof and heating system. Six months later, B’s monthly condominium fee doubles in order to pay for the repairs. B sells the condominium in 2004 because he is unable to afford the new condominium fee along with a monthly mortgage payment. The safe harbors of paragraph (e)(2) of this section do not apply. However, under the facts and circumstances, the primary reason for the sale, the doubling of the condominium fee, is an unforeseen circumstance because B could not reasonably have anticipated that the condominium fee would double at the time he purchased and occupied the property. Consequently, the sale of the condominium is by reason of unforeseen circumstances and B is entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 5. In 2003, C buys a house that he uses as his principal residence. The property is located on a heavily traveled road. C sells the property in 2004 because C is disturbed by the traffic. The safe harbors of paragraph (e)(2) of this section do not apply. Under the facts and circumstances, the primary reason for the sale, the traffic, is not an unforeseen circumstance because C could reasonably have anticipated the traffic at the time he purchased and occupied the house. Consequently, the sale of the house is not by reason of unforeseen circumstances and C is not entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 6. In 2003, D and her fiancé E buy a house and live in it as their principal residence. In 2004, D and E cancel their wedding plans and E moves out of the house. Because D cannot afford to make the monthly mortgage payments alone, D and E sell the house in 2004. The safe harbors of paragraph (e)(2) of this section do not apply. However, under the facts and circumstances, the primary reason for the sale, the broken engagement, is an unforeseen circumstance because D and E could not reasonably have anticipated the broken engagement at the time they purchased and occupied the house. Consequently, the sale is by reason of unforeseen circumstances and D and E are each entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 7. In 2003, F buys a small condominium that she uses as her principal residence. In 2005, F receives a promotion and a large increase in her salary. F sells the condominium in 2004 and purchases a house because she can now afford the house. The safe harbors of paragraph (e)(2) of this section do not apply. Under the facts and circumstances, the primary reason for the sale of the house, F’s salary increase, is an improvement in F’s financial circumstances. Under paragraph (e)(1) of this section, an improvement in financial circumstances, even if the result of unforeseen circumstances, does not qualify for the reduced maximum exclusion by reason of unforeseen circumstances under section 121(c)(2).

Example 8. In April 2003, G buys a house that he uses as his principal residence. G sells his house in October 2004 because the house has greatly appreciated in value, mortgage rates have substantially decreased, and G can afford a bigger house. The safe harbors of paragraph (e)(2) of this section do not apply. Under the facts and circumstances, the primary reasons for the sale of the house, the changes in G’s house value and in the mortgage rates, are an improvement in G’s financial circumstances. Under paragraph (e)(1) of this section, an improvement in financial circumstances, even if the result of unforeseen circumstances, does not qualify for the reduced maximum exclusion by reason of unforeseen circumstances under section 121(c)(2).

Example 9. H works as a police officer for City X. In 2003, H buys a condominium that he uses as his principal residence. In 2004, H is assigned to City X’s K-9 unit and is required to care for the police service dog at his home. Because H’s condominium association does not permit H to have a dog in his condominium, in 2004 he sells the condominium and buys a house. The safe harbors of paragraph (e)(2) of this section do not apply. However, under the facts and circumstances, the primary reason for the sale, H’s assignment to the K-9 unit, is an unforeseen circumstance because H could not reasonably have anticipated his assignment to the K-9 unit at the time he purchased and occupied the condominium. Consequently, the sale of the condominium is by reason of unforeseen circumstances and H is entitled to claim a reduced maximum exclusion under section 121(c)(2).

Example 10. In 2003, J buys a small house that she uses as her principal residence. After J wins the lottery, she sells the small house in 2004 and buys a bigger, more expensive house. The safe harbors of paragraph (e)(2) of this section do not apply. Under the facts and circumstances, the primary reason for the sale of the house, winning the lottery, is an improvement in J’s financial circumstances. Under paragraph (e)(1) of this section, an improvement in financial circumstances, even if the result of unforeseen circumstances, does not qualify for the reduced maximum exclusion under section 121(c)(2).

(f) Qualified individual. For purposes of this section, qualified individual means—

(1) The taxpayer;

(2) The taxpayer’s spouse;

(3) A co-owner of the residence;

(4) A person whose principal place of abode is in the same household as the taxpayer; or

(5) For purposes of paragraph (d) of this section, a person bearing a relationship specified in sections 152(a)(1) through 152(a)(8) (without regard to qualification as a dependent) to a qualified individual described in paragraphs (f)(1) through (4) of this section, or a descendant of the taxpayer’s grandparent.

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(h) Effective dates. Paragraphs (a) and (g) of this section are applicable for sales and exchanges on or after December 24, 2002. Paragraphs (b) through (f) of this section are applicable for sales and exchanges on or after August 13, 2004.

(a) In general. Under section 121(d)(9), a taxpayer who is serving (or whose spouse is serving) on qualified official extended duty as a member of the uniformed services or Foreign Service of the United States may elect to suspend the running of the 5-year period of ownership and use during such service but for not more than 10 years. The election does not suspend the running of the 5-year period for any period during which the running of the 5-year period with respect to any other property of the taxpayer is suspended by an election under section 121(d)(9).

(b) Manner of making election. The taxpayer makes the election under section 121(d)(9) and this section by filing a return for the taxable year of the sale or exchange of the taxpayer’s principal residence that does not include the gain in the taxpayer’s gross income.

(c) Application of election to closed years. A taxpayer who would otherwise qualify under §§1.121-1 through 1.121-4 to exclude gain from a sale or exchange of a principal residence on or after May 7, 1997, may elect to apply section 121(d)(9) and this section for any years for which a claim for refund is barred by operation of any law or rule of law by filing an amended return before November 11, 2004.

(d) Example. The provisions of this section are illustrated by the following example:

Example. B purchases a house in Virginia in 2003 that he uses as his principal residence for 3 years. For 8 years, from 2006 through 2014, B serves on qualified official extended duty as a member of the Foreign Service of the United States in Brazil. In 2015, B sells the house. B did not use the house as his principal residence for 2 of the 5 years preceding the sale. Under section 121(d)(9) and this section, however, B may elect to suspend the running of the 5-year period of ownership and use during his 8-year period of service with the Foreign Service in Brazil. If B makes the election, the 8-year period is not counted in determining whether B used the house for 2 of the 5 years preceding the sale. Therefore, B may exclude the gain from the sale of the house under section 121.

(e) Effective date. This section is applicable for sales and exchanges on or after May 7, 1997.

Approved July 29, 2004.

The proposed regulations propose two changes to the remedial action rules contained in §§1.141-12 and 1.142-2. First, the proposed regulations would change the definition of nonqualified bonds under §1.141-12 to provide that the nonqualified bonds are a portion of the outstanding bonds in an amount that, if the remaining bonds were issued on the date on which the deliberate action occurs, the remaining bonds would not satisfy the private business use test or private loan financing test, as applicable. For this purpose, the proposed regulations provide that the amount of private business use is the greatest percentage of private business use in any one-year period commencing with the deliberate action.

Second, the proposed regulations would amend the provisions of §1.141-12 (relating to redemption or defeasance) and §1.142-2 relating to allocations of nonqualified bonds. Under the proposed regulations, allocations of nonqualified bonds must be made on a pro rata basis, except that an issuer may treat any bonds of an issue as the nonqualified bonds so long as (i) the remaining weighted average maturity of the issue, determined as of the date on which the nonqualified bonds are redeemed or defeased (determination date), and excluding from the determination the nonqualified bonds redeemed or defeased by the issuer, is not greater than (ii) the remaining weighted average maturity of the issue, determined as of the determination date, but without regard to the redemption or defeasance of any bonds (including the nonqualified bonds) occurring on the determination date.

The proposed regulations also would amend §§1.141-15(e) and 1.141-16(c) to provide that for bonds issued before May 16, 1997, issuers may apply §§1.141-12 and 1.142-2 without regard to the 10¹/₂ year limitation on defeasances contained in those regulations.

Public comments were received regarding the proposed regulations. These comments request that the amount of nonqualified bonds be determined in a manner consistent with the general measurement rules under § 1.141-3(g). Because of the interrelationship between the remedial action provisions of §1.141-12 and the allocation and accounting rules of §1.141-6 (which are currently reserved), the proposed regulations under §§1.141-12 and 1.141-15 are not being finalized at this time. It is anticipated that these proposed regulations will be finalized in connection with the provision of the allocation and accounting rules.

Commentators agreed with the proposed change that allows any bonds of an issue to be treated as the nonqualified bonds, provided that the redemption or defeasance does not have the effect of extending the weighted average maturity (WAM) of the issue. However, the commentators stated that under the bond indentures for certain fixed rate bonds, the redemption or defeasance of bonds with the longest maturities in an issue could result in an extension of the WAM of the issue. Under some bond indentures, optional redemptions of a portion of a term bond must be used first to reduce the earliest mandatory sinking fund payments on the bond. In this case, the redemption or defeasance of the longest bonds could result in an extension of the WAM. Commentators indicated that requiring an issuer to use the pro rata allocation method in these circumstances is inappropriate and recommended that the regulations be revised to permit the longer bonds to be treated as the nonqualified bonds, which is permitted under the existing regulations. The IRS and Treasury Department agree that additional flexibility should be provided for outstanding bonds with bond indentures that prevent compliance with the WAM rule, but believe that extensions of the WAM should not be permitted on a prospective basis. As a result, the final regulations provide that for purposes of §1.142-2(e)(2), in addition to the allocation methods permitted in §1.142-2(e)(2), an issuer may treat bonds with the longest maturities (determined on a bond-by-bond basis) as the nonqualified bonds, but only with respect to failures to properly use proceeds that occur on or after May 14, 2004, with respect to bonds sold before August 13, 2004.

Other comments were received that are beyond the scope of this project. The IRS and Treasury Department continue to consider these comments.

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(d) Certain remedial actions.

(1) General rule.

(2) Special rule for allocations of nonqualified bonds.

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Par. 3. Section 1.141-16 is amended by revising paragraph (c) and adding paragraph (d) to read as follows:

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(c) Permissive application. The regulations designated in paragraph (a) of this section may be applied by issuers in whole, but not in part, to bonds outstanding on the effective date. For this purpose, issuers may apply §1.142-2 without regard to paragraph (c)(3) thereof to failures to properly use proceeds that occur on or after April 21, 2003.

(d) Certain remedial actions—(1) General rule. The provisions of §1.142-2(e) apply to failures to properly use proceeds that occur on or after August 13, 2004, and may be applied by issuers to failures to properly use proceeds that occur on or after May 14, 2004, provided that the bonds are subject to §1.142-2.

(2) Special rule for allocations of nonqualified bonds. For purposes of §1.142-2(e)(2), in addition to the allocation methods permitted in §1.142-2(e)(2), an issuer may treat bonds with the longest maturities (determined on a bond-by-bond basis) as the nonqualified bonds, but only with respect to failures to properly use proceeds that occur on or after May 14, 2004, with respect to bonds sold before August 13, 2004.

Par. 4. Section 1.142-0 is amended by revising the entry to the table for §1.142-2 paragraph (e) to read as follows:

* * * * *

* * * * *

(e) * * *

(1) Amount of nonqualified bonds.

(2) Allocation of nonqualified bonds.

* * * * *

Par. 5. Section 1.142-2 is amended by revising paragraph (e) to read as follows:

* * * * *

(e) Nonqualified bonds—(1) Amount of nonqualified bonds. For purposes of this section, the nonqualified bonds are a portion of the outstanding bonds in an amount that, if the remaining bonds were issued on the date on which the failure to properly use the proceeds occurs, at least 95 percent of the net proceeds of the remaining bonds would be used to provide an exempt facility. If no proceeds have been spent to provide an exempt facility, all of the outstanding bonds are nonqualified bonds.

(2) Allocation of nonqualified bonds. Allocations of nonqualified bonds must be made on a pro rata basis, except that an issuer may treat any bonds of an issue as the nonqualified bonds so long as—

(i) The remaining weighted average maturity of the issue, determined as of the date on which the nonqualified bonds are redeemed or defeased (determination date), and excluding from the determination the nonqualified bonds redeemed or defeased by the issuer to meet the requirements of paragraph (c) of this section, is not greater than

(ii) The remaining weighted average maturity of the issue, determined as of the determination date, but without regard to the redemption or defeasance of any bonds (including the nonqualified bonds) occurring on the determination date.

Approved July 18, 2004.

* * * * *

(d) Domestic and foreign business entities. [Reserved]. For further guidance, see §301.7701-1T.

* * * * *

Par 3. Section 301.7701-1T is added to read as follows:

(a) through (c) [Reserved]. For further guidance, see §301.7701-1(a) through (c).

(d) Domestic and foreign entities. See §301.7701-5T for the rules that determine whether a business entity is domestic or foreign.

(e) through (f) [Reserved].

Par. 4. In §301.7701-2, paragraph (b)(9) is added to read as follows:

* * * * *

(b) * * *

(9) [Reserved]. For further guidance, see §301.7701-2T(b)(9).

* * * * *

Par. 5. Section 301.7701-2T is added to read as follows:

(a) through (b)(8) [Reserved] For further guidance, see §301.7701-2 (a) through (b)(8).

(b)(9) Entities with multiple charters. (i) An entity created or organized under the laws of more than one jurisdiction if the rules of this section would treat it as a corporation as a result of its formation in any one of the jurisdictions in which it is created or organized. (The determination of a business entity’s classification is made independently of the determination whether the entity is domestic or foreign. See §301.7701-5T for the rules that determine whether a business entity is domestic or foreign.)

(ii) Examples. The following examples illustrate the rule of this paragraph (b)(9):

Example 1. (i) Facts. X is an entity with a single owner organized under the laws of Country A as an entity that is specifically mentioned in paragraph (b)(8)(i) of this section. Under the rules of this section, such an entity generally is a corporation for Federal tax purposes. Several years after its formation, X files a certificate of domestication in State B as a limited liability company (LLC). Under the laws of State B, X is considered to be created or organized in State B as a LLC upon the filing of the certificate of domestication and is therefore subject to the laws of State B. Under the rules of this section and §301.7701-3, a LLC with a single owner organized only in State B is disregarded as an entity separate from its owner for Federal tax purposes (absent an election to be treated as an association). Neither Country A nor State B law requires X to terminate its charter in Country A as a result of the domestication, and in fact X does not terminate its charter in Country A. Consequently, X is now organized in more than one jurisdiction.

(ii) Result. X remains organized under the laws of Country A as an entity that is specifically mentioned in §301.7701-2(b)(8)(i), and as such, it is an entity that generally is treated as a corporation under the rules of this section. Therefore, X is a corporation for Federal tax purposes because the rules of this section would treat X as a corporation as a result of its formation in one of the jurisdictions in which it is created or organized.

Example 2. (i) Facts. Y is an entity that is incorporated under the laws of State A and that has two shareholders. Under the rules of this section, an entity incorporated under the laws of State A is a corporation for Federal tax purposes. Several years after its formation, Y files a certificate of continuance in Country B as an unlimited company. Under the laws of Country B, upon filing a certificate of continuance, Y is treated as organized in Country B. Under the rules of this section and §301.7701-3, an unlimited company organized only in Country B that has more than one owner is treated as a partnership for Federal tax purposes (absent an election to be treated as an association). Neither State A nor Country B law requires Y to terminate its charter in State A as a result of the continuance, and in fact Y does not terminate its charter in State A. Consequently, Y is now organized in more than one jurisdiction.

(ii) Result. Y remains organized in State A as a corporation, an entity that is treated as a corporation under the rules of this section. Therefore, Y is a corporation for Federal tax purposes because the rules of this section would treat Y as a corporation as a result of its formation in one of the jurisdictions in which it is created or organized.

Example 3. (i) Facts. Z is an entity that has more than one owner and that is recognized under the laws of Country A as an unlimited company organized in Country A. Under the rules of this section and §301.7701-3, an unlimited company organized only in Country A with more than one owner is treated as a partnership for Federal tax purposes (absent an election to be treated as an association). At the time Z was formed, it was also organized as a public limited company under the laws of Country B. Under the rules of this section, a public limited company organized only in Country B generally is treated as a corporation for Federal tax purposes.

(ii) Result. Z is organized in Country B as a public limited company, an entity that generally is treated as a corporation under the rules of this section. Therefore, Z is a corporation for Federal tax purposes because the rules of this section would treat Z as a corporation as a result of its formation in one of the jurisdictions in which it is created or organized.

(c) through (e) [Reserved]. For further guidance, see §301.7701-2(c) through (e).

(f) Special effective date. The rules of this section apply as of August 12, 2004, to all business entities existing on or after that date.

Par. 6. In §301.7701-3, the last sentence of paragraph (b)(3)(i) is revised to read as follows:

* * * * *

(b) * * *

(3) * * * (i) * * *For special rules regarding the classification of such entities prior to the effective date of this section, see paragraph (h)(2) of this section.

* * * * *

Par. 7. Section 301.7701-5 is revised to read as follows:

Par. 8. Section 301.7701-5T is added to read as follows:

(a) Domestic and foreign entities. A business entity (including an entity that is disregarded as separate from its owner) is domestic if it is created or organized as any type of entity (including, but not limited to, a corporation, unincorporated association, general partnership, limited partnership, and limited liability company) in the United States, or under the law of the United States or of any State. Accordingly, a business entity that is created or organized both in the United States and in a foreign jurisdiction is a domestic entity. A business entity (including an entity that is disregarded as separate from its owner) is foreign if it is not domestic. (The determination of whether an entity is domestic is made independently of the determination of its classification for Federal tax purposes. See §§301.7701-2, 301.7701-2T, and 301.7701-3 for the rules governing the classification of entities.)

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

Example 1. (i) Facts. Y is an entity that is created or organized under the laws of Country A as a public limited company. It is also an entity that is organized as a limited liability company (LLC) under the laws of State B. Y has been classified as a corporation for Federal tax purposes under the rules of §§301.7701-2, 301.7701-2T, and 301.7701-3.

(ii) Result. Y is a domestic corporation because it is an entity that is classified as a corporation and it is organized as an entity under the laws of State B.

Example 2. (i) Facts. P is an entity with more than one owner organized under the laws of Country A as an unlimited company. It is also an entity that is organized as a general partnership under the laws of State B. P has been classified as a partnership for Federal tax purposes under the rules of §§301.7701-2, 301.7701-2T, and 301.7701-3.

(ii) Result. P is a domestic partnership because it is an entity that is classified as a partnership and it is organized as an entity under the laws of State B.

(c) Effective date. The rules of this section apply as of August 12, 2004, to all business entities existing on or after that date.

Approved July 21, 2004.

Under section 2642(a)(3), in order to constitute a qualified severance, the single trust must be divided on a fractional basis. Under the proposed regulations, each new trust must receive assets with a value equal to a fraction or percentage of the total value of the trust assets. Thus, for example, the severance of a single trust on the basis that one trust is to be funded with 30% of the trust assets and that the other trust is to be funded with the remaining 70% of the trust assets would satisfy this requirement. Similarly, a severance stated in terms of a fraction of the trust assets such that one trust is to receive, for example, that fraction of the trust assets the numerator of which is $1,500,000 and the denominator of which is the fair market value of the trust assets on a specified date and the second trust is to receive the remaining fraction, would also satisfy this requirement. However, the severance of a trust based on a pecuniary amount (for example, severance of a single trust on the basis that one trust is to be funded with $1,500,000, and the other trust is to be funded with the balance of the trust corpus) would not satisfy this requirement.

The proposed regulations provide that each separate trust need not be funded with a pro rata portion of each asset held by the original trust. Rather, the separate trusts may be funded on a non pro rata basis (that is, where each resulting trust does not receive a pro-rata portion of each asset) provided that funding is based on the total fair market value of the assets on the date of funding. This avoids the necessity of dividing each and every asset on a fractional basis to fund the severed trusts.

Under section 2642(a)(3)(B)(i)(II), the new trusts created as a result of the qualified severance must provide in the aggregate for the same succession of interests of beneficiaries as provided in the original trust. Under the regulations, the beneficiaries of each separate trust resulting from the severance need not be identical to those of the original trust. In the case of trusts that grant the trustee the discretionary power to make non pro rata distributions to beneficiaries, the separate trusts will be considered to have the same succession of interests of beneficiaries if the terms of the separate trusts are the same as the terms of the original trust, the severance does not shift a beneficial interest in the trust to any beneficiary in a lower generation (as determined under section 2651) than the person or persons who held the beneficial interest in the original trust, and the severance does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. This rule for discretionary trusts is intended to facilitate the severance of trusts along family lines.

In this regard, the Treasury Department and the IRS recognize that in many cases involving discretionary trusts, when the members of two or more families are beneficiaries, the parties may desire to divide the trust along family lines so that one trust is established exclusively for the benefit of one family and one trust is established exclusively for the benefit of another family. If the inclusion ratio of the trust is between zero and one, section 2642(a)(3)(B)(ii) would ordinarily, as a practical matter, preclude the division of the trust along family lines because the section requires that the severance result in one trust with an inclusion ratio of zero and one trust with an inclusion ratio of one. However, under the proposed regulations, a similar result may be accomplished through a series of severances; that is, first a division of the trust based on the inclusion ratio, and then a division of each resulting trust along family lines.

Finally, §26.2601-1(b)(4) of the regulations contains rules for determining when certain actions with respect to a non-chapter 13 trust (a trust that was irrevocable on or before September 25, 1985) will not cause the trust to lose its exempt status. In particular, under §26.2601-1(b)(4)(i)(D)(1), a modification (including a severance) of a non-chapter 13 trust will not cause the trust to be subject to the provisions of chapter 13 if the modification does not (1) shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person or persons who held the beneficial interest prior to the modification or (2) extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

Under the proposed regulations, the rules in §26.2601-1(b)(4) will continue to apply to severances (and other actions) with respect to trusts created on or before September 25, 1985. However, the post-2000 severance of a trust created after September 25, 1985, will be governed by section 2642(a)(3) and the applicable regulations.

The proposed regulations provide that a qualified severance is to be reported by filing a Form 706-GS(T), “Generation-Skipping Transfer Tax Return for Terminations,” or such other form that may be published by the IRS in the future that is specifically designated to be utilized to report qualified severances. When Form 706-GS(T) is utilized, the filer should write “Qualified Severance” in red at the top of the return and attach a Notice of Qualified Severance to the return that clearly identifies the trust that is being severed and the new trusts created as a result of the severance. The notice must also provide the inclusion ratio of the trust that was severed and the inclusion ratios of the new trusts resulting from the severance. The return and attached notice must be filed even if the severance does not result in a taxable termination. A transition rule applies in the case of severances occurring before the date of publication of the final regulations.

The proposed regulations provide that a qualified severance will not constitute an exchange of property for other property differing materially either in kind or in extent, for purposes of section 1001, provided that: (1) an applicable state statute or the governing instrument authorizes the trustee to sever the trust; and (2) if the separate trusts created by the severance are funded on a non pro rata basis, as discussed in Section I above, an applicable state statute or the governing instrument authorizes the trustee to fund the separate trusts on a non pro rata basis. If section 1001 does not apply in accordance with this standard, then under section 1015, the basis of the trust assets will be the same after the severance as the basis of those assets before the severance, and under section 1223, the holding periods of the assets distributed to the new trusts will include the holding period of the assets in the original trust.

Section 2642(a)(3) supercedes the regulatory rules contained in §26.2654-1(b). Accordingly, under the proposed regulations, the applicability of §26.2654-1(b) is limited to severances occurring on or before December 31, 2000. The regulations under section 2642(a)(3), as proposed, apply to severances occurring on or after the date of publication of the Treasury decision adopting these rules as final regulations. In the case of severances occurring after December 31, 2000, and before publication of final regulations, taxpayers may rely on any reasonable interpretation of section 2642(a)(3) as long as reasonable notice concerning the severance and identification of the trusts involved has been given to the IRS.

The regulations under section 1001, as proposed, apply to severances occurring on or after the date of publication of the Treasury decision adopting these rules as final regulations. However, taxpayers may apply the proposed regulations under section 1001 to severances occurring after August 24, 2004, and before publication of final regulations.

* * * * *

(h) Qualified severances of trusts—(1) In general. A severance of a trust that meets the requirements of §26.2642-6 is not an exchange of property for other property differing materially either in kind or in extent if—

(i) An applicable state statute or the governing instrument authorizes the trustee to sever the trust; and

(ii) If the separate trusts created by the severance are funded on a non pro rata basis as provided in §26.2642-6(b)(3), an applicable state statute or the governing instrument authorizes the trustee to fund the separate trusts on a non pro rata basis.

(2) Effective date. This paragraph (h) applies to severances occurring on or after the date these regulations are published as final regulations in the Federal Register. Taxpayers may apply this paragraph (h) to severances occurring on or after August 24, 2004, and before the date these regulations are published as final regulations in the Federal Register.

* * * * *

(a) In general.

(b) Requirements for a qualified severance.

(c) Time for making a qualified severance.

(d) Irrevocable trusts.

(e) Examples.

(f) Effective date.

* * * * *

* * * * *

(b) Division of a trust included in the gross estate occurring on or before December 31, 2000.

* * * * *

(c) Qualified severance occurring after December 31, 2000.

Par. 5. Section 26.2642-6 is added to read as follows:

(a) In general. If a trust is severed into two or more trusts, the separate trusts resulting from the severance will be treated as separate trusts for generation-skipping transfer tax purposes only if the severance is a qualified severance. In general, the rules in this section are applicable only for purposes of the generation-skipping transfer tax and are not applicable in determining, for example, whether the severance may result in a gift subject to gift tax, cause the trust to be included in the gross estate of a beneficiary, or result in a realization of gain for purposes of section 1001. See §1.1001-1(h) for rules relating to whether a qualified severance will constitute an exchange of property for other property differing materially either in kind or in extent.

(b) Requirements for a qualified severance. For purposes of this section, a qualified severance is a division of a single trust into two or more trusts that meets each of the following requirements:

(1) The single trust is severed pursuant to the terms of the governing instrument, or pursuant to applicable local law.

(2) The severance is effective under local law.

(3) The single trust is severed on a fractional basis, such that each new trust is funded with a fraction or percentage of the entire trust. For this purpose, the fraction or percentage may be determined by means of a formula (for example, that fraction of the trust the numerator of which is equal to transferor’s unused GST tax exemption, and the denominator of which is the fair market value of the trust assets on the date of severance). The severance of a trust based on a pecuniary amount does not satisfy this requirement. For example, the severance of a trust would not be a qualified severance if the trust was divided into two trusts, with one trust to be funded with $1,500,000 and the other trust to be funded with the balance of the original trust assets. For purposes of this paragraph, the separate trusts resulting from the severance may be funded with the appropriate fraction, percentage, or pro rata portion of each asset held by the undivided trust, or on a non pro rata basis. However, if funded on a non pro rata basis, each resulting trust must be funded by applying the appropriate fraction or percentage to the total fair market value of the trust assets as of the date of funding.

(4) The terms of the new trusts must provide, in the aggregate, for the same succession of interests of beneficiaries as are provided in the original trust. This requirement will be satisfied if the beneficiaries of the separate trusts and the interests of the beneficiaries with respect to the separate trusts, when the separate trusts are viewed collectively, are identical to the beneficiaries and their respective beneficial interests with respect to the original trust before severance. With respect to trusts from which discretionary distributions may be made to any one or more beneficiaries on a non pro rata basis, this requirement will be satisfied if the terms of each of the separate trusts are the same as the terms of the original trust (even though each permissible distributee of the original trust might be a beneficiary of only one of the separate trusts), the severance does not shift a beneficial interest in the trust to any beneficiary in a lower generation (as determined under section 2651) than the person or persons who held the beneficial interest in the original trust, and the severance does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

(5) In the case of a severance after GST tax exemption has been allocated to the trust as a result of an allocation, deemed allocation, or automatic allocation pursuant to the rules contained in section 2632, if the trust has an inclusion ratio as defined in §26.2642-1 that is greater than zero and less than one, then the trust may be severed initially only into two trusts. One separate trust must receive that fractional share of the total value of all trust assets as of the date of funding equal to the applicable fraction, as defined in §26.2642-1(b) and (c), with respect to the single trust immediately before the severance. The other separate trust must receive the balance of the trust assets. The trust receiving the fractional share equal to the applicable fraction shall have an inclusion ratio of zero, and the other trust shall have an inclusion ratio of one. If the applicable fraction with respect to the original trust is .50, then with respect to the two equal trusts resulting from the severance, the Trustee may designate which of the resulting trusts will have an inclusion ratio of zero and which will have an inclusion ratio of one. Each separate trust resulting from the severance may be further divided in accordance with the rules of this section.

(6) The severance is reported by filing Form 706-GS(T), “Generation-Skipping Transfer Tax Return for Terminations,” or such other form that may be published by the IRS that is specifically designated to be utilized to report qualified severances. When Form 706-GS(T) is utilized, the filer should write “Qualified Severance” in red at the top of the return and attach a Notice of Qualified Severance to the return. The notice must contain: a statement identifying the trust that is severed, the name of the transferor of the trust, the date of creation, the tax identification number, and the inclusion ratio with respect to the trust before severance; and a statement identifying each of the new trusts created as a result of the severance, the name and tax identification number of each new trust, the fraction of trust assets received by each new trust, other details explaining the basis for funding each new trust (a fraction of the total fair market value of the assets on the date of funding or a fraction of each asset), and the inclusion ratio of each new trust. The return and attached notice must be filed by April 15th of the year immediately following the year during which the severance occurred or the last day of the period covered by an extension of time, if an extension of time is granted.

(c) Time for making a qualified severance. A trust may be severed in a qualified severance at any time prior to the termination of the trust. Thus, provided that the separate trusts resulting from the severance continue in existence after the severance, a trust may be severed in a qualified severance either before or after: GST tax exemption has been allocated to the trust; a taxable event has occurred with respect to the trust; or an addition has been made to the trust. A qualified severance is effective at the time the trust is divided into two or more separate trusts. Thus, a qualified severance has no effect on a taxable termination as defined in section 2612(a) or a taxable distribution as defined in section 2612(b) that occurred prior to the effective date of the qualified severance.

(d) Irrevocable trusts. See §26.2601-1(b)(4) for rules regarding severances and other actions with respect to trusts that were irrevocable on September 25, 1985.

(e) Examples. The rules of this section are illustrated by the following examples:

Example 1. Formula severance. T’s will establishes a testamentary marital trust (Trust) that qualifies as qualified terminable interest property (QTIP) under section 2056(b)(7). Trust provides that all trust income is to be paid to T’s spouse for life. On the spouse’s death, the trust corpus is to be held in further trust for the benefit of T’s then-living descendants. On T’s date of death in January of 2004, T’s unused GST tax exemption is $1,200,000, $200,000 of which T’s executor will allocate to bequests to T’s grandchildren. Prior to the due date for filing the Form 706, “United States Estate (and Generation-Skipping Transfer) Tax Return,” for T’s estate, and thus, prior to the allocation of any GST tax exemption with respect to Trust, T’s executor, pursuant to applicable state law, divides Trust into two separate trusts, Trust 1 and Trust 2. Trust 1 is to be funded with that fraction of the Trust assets, the numerator of which is $1,000,000, and the denominator of which is the value of the Trust assets as finally determined for federal estate tax purposes. Trust 2 is to be funded with the balance of the Trust assets. On the Form 706 filed for the estate, T’s executor makes a QTIP election under section 2056(b)(7) with respect to Trust 1 and Trust 2 and a “reverse” QTIP election under section 2652(a)(3) with respect to Trust 1. Further, T’s executor allocates T’s available GST tax exemption to Trust 1. If the requirements of section 2642(a)(3) are otherwise satisfied, the severance constitutes a qualified severance. Accordingly, Trust 1 and Trust 2 are treated as separate trusts, and the GST tax elections and GST tax exemption allocation are recognized and effective for generation-skipping transfer tax purposes.

Example 2. Severance of single trust with one income beneficiary. T’s will establishes a testamentary trust providing that income is to be paid to T’s sister, S, for her life. On S’s death, one-half of the corpus is to be paid to T’s child, C, or to C’s estate if C fails to survive S and one-half of the corpus is to be paid to T’s grandchild, GC, or to GC’s estate if GC fails to survive S. Prior to the due date for filing the Form 706, T’s executor, pursuant to applicable state law, divides the testamentary trust into two separate trusts, Trust 1 and Trust 2, with each trust receiving 50 percent of the current value of the assets of the original trust. Trust 1 provides that trust income is to be paid to S for life with remainder to C or C’s estate, and Trust 2 provides that trust income is to be paid to S for life with remainder to GC or GC’s estate. Because Trust 1 and Trust 2 provide for the same succession of interests in the aggregate as provided in the original trust, the severance will constitute a qualified severance if the requirements of section 2642(a)(3) are otherwise satisfied. On the Form 706, T’s executor may allocate T’s available GST tax exemption to Trust 2.

Example 3. Severance of discretionary trust. T’s will establishes a testamentary trust (Trust) providing that income is to be paid from time to time in such amounts as the trustee deems advisable to T’s children, A and B, and to their respective descendants. In addition, the trustee may distribute corpus to any trust beneficiary in such amounts as the trustee deems advisable. On the death of the last to die of A and B, the trust is to terminate and the corpus is to be distributed in two equal shares, one share to the descendants of each child, per stirpes. Prior to the due date for filing the Form 706, T’s executor, pursuant to applicable state law, divides Trust into two separate trusts, Trust 1 and Trust 2. Trust 1 provides that income is to be paid in such amounts as the trustee deems advisable to A and A’s descendants. In addition, the trustee may distribute corpus to any trust beneficiary in such amounts as the trustee deems advisable. On the death of A, Trust 1 is to terminate and the corpus is to be distributed to the descendants of A, per stirpes, but if A dies with no living descendants, the principal will be added to Trust 2. Trust 2 contains identical provisions, except that B and B’s descendants are the trust beneficiaries and, if B dies with no living descendants, the principal will be added to Trust 1. Because Trust 1 and Trust 2 provide for the same beneficiaries and the same succession of interests in the aggregate as provided in Trust, and because the severance does not shift any beneficial interest in the trust to a beneficiary who occupies a lower generation than the person or persons who held the beneficial interest in Trust, the severance constitutes a qualified severance if the requirements of section 2642(a)(3) are otherwise satisfied.

Example 4. Severance of single trust with two income beneficiaries. T’s will establishes a testamentary trust (Trust) providing that Trust income is to be paid to T’s children, A and B, for their joint lives. Upon the death of the first to die of A and B, the income will be paid to the survivor. At the death of the survivor of A and B, the corpus is to be distributed equally to T’s grandchildren, W and X (with any then-deceased grandchild’s share being paid to that grandchild’s estate). W is A’s child and X is B’s child. Prior to the due date for filing Form 706, T’s executor divides the testamentary trust equally into two separate trusts, Trust 1 and Trust 2. Trust 1 provides that trust income is to be paid to A for life and, on A’s death, the remainder is to pass to W. Trust 2 provides that trust income is to be paid to B for life and the remainder on B’s death to X. Because Trust 1 and Trust 2 do not provide A and B with contingent survivor income interests as provided under the terms of the original trust, Trust 1 and Trust 2 do not provide for the same succession of interests in the aggregate as provided in Trust. Therefore, the division is not a qualified severance, and Trust 1 and Trust 2 are treated as one trust. If, however, in this example, Trust 1 instead provides that trust income is to be paid to A for life and then to B (if B survives A), with remainder to W, and if Trust 2 instead provides that trust income is to be paid to B for life and then to A (if A survives B), with remainder to X, then Trust 1 and Trust 2 would provide for the same succession of interests in the aggregate as provided in Trust, and the severance would constitute a qualified severance.

Example 5. Severance of a trust with a 50% inclusion ratio. On September 1, 2004, T transfers $100,000 to a trust for the benefit of T’s grandchild, GC. On a timely filed Form 709, “United States Gift (and Generation-Skipping Transfer) Tax Return,” reporting the transfer, T allocates all of T’s remaining GST tax exemption ($50,000) to the trust. As a result of the allocation, the applicable fraction with respect to the trust is .50 [$50,000 (the amount of GST tax exemption allocated to the trust) divided by $100,000 (the value of the property transferred to the trust)]. The inclusion ratio with respect to the trust is .50 [1 — .50]. In 2006, pursuant to authority granted under applicable state law, the trustee severs the trust into two trusts, Trust 1 and Trust 2, each of which receives a 50 percent fractional share of the total value of all trust assets at that time. Because the applicable fraction with respect to the original trust is .50 and the trust was severed into two equal trusts, the trustee may designate which trust has an inclusion ratio of one, and which trust has an inclusion ratio of zero. Accordingly, in the Notice of Qualified Severance reporting the severance, the trustee designates Trust 1 as having an inclusion ratio of zero, and Trust 2 as having an inclusion ratio of one.

Example 6. Funding of severed trusts on a non pro rata basis. T’s will establishes a testamentary trust (Trust) for the benefit of T’s descendants, to be funded with T’s stock in Corporation A and Corporation B. T dies on May 1, 2004, at which time the Corporation A stock included in T’s gross estate has a fair market value of $100,000 and the stock of Corporation B included in T’s gross estate has a fair market value of $200,000.On a timely filed Form 706, T’s executor allocates all of T’s remaining GST tax exemption ($270,000) to Trust. As a result of the allocation, the applicable fraction with respect to Trust is .90 [$270,000 (the amount of GST tax exemption allocated to the trust) divided by $300,000 (the value of the property transferred to the trust)]. The inclusion ratio with respect to Trust is .10 [1 — .90]. On August 1, 2008, when the value of the Trust assets totals $500,000, consisting of Corporation A stock worth $450,000 and Corporation B stock worth $50,000, the trustee severs Trust into two identical trusts, Trust 1 and Trust 2. The terms of the instrument severing Trust provides that Trust 1 is to be funded on a non pro rata basis with assets having a fair market value on the date of funding equal to 90% of the value of the Trust assets on that date, and Trust 2 is to be funded with assets having a fair market value on the date of funding equal to 10% of the value of the Trust assets on that date. Also on August 1, 2008, the trustee funds Trust 1 with all of the Corporation A stock and funds Trust 2 with all of the Corporation B stock. Accordingly, Trust 1 is funded with assets having a value equal to 90% of the value of Trust as of the date of funding, August 1, 2008, and Trust 2 is funded with assets having a value equal to 10% of the value of Trust as of the date of funding. Therefore, if the requirements of section 2642(a)(3) are otherwise satisfied, the severance constitutes a qualified severance. Trust 1 will have an inclusion ratio of zero and Trust 2 will have an inclusion ratio of one.

Example 7. Severance of a trust along family lines. T dies on October 1, 2004. T’s will establishes a testamentary trust (Trust) to be funded with $1,000,000. Trust income is to be paid to T’s child, S, for S’s life. On S’s death, Trust is to terminate and the assets are to be divided equally among T’s three grandchildren, GC1, GC2, and GC3 (or their respective descendants, per stirpes). On a timely filed Form 706, T’s executor allocates all of T’s remaining GST tax exemption ($300,000) to Trust. As a result of the allocation, the applicable fraction with respect to the trust is .30 [$300,000 (the amount of GST tax exemption allocated to the trust) divided by $1,000,000 (the value of the property transferred to the trust)]. The inclusion ratio with respect to the trust is .70 [1 — .30]. On June 1, 2007, the trustee determines that it is in the best interest of the beneficiaries to sever Trust to provide a separate trust for each of T’s three grandchildren and their respective families. The trustee severs Trust into two identical trusts, Trust 1 and Trust 2, each trust providing that trust income is to be paid to S, for life, and on S’s death, the trust is to terminate and the assets are to be divided equally among GC1, GC2, and GC3 (or their respective descendants, per stirpes). The terms of the instrument severing Trust provide that Trust 1 is to receive 30% of the Trust assets and Trust 2 is to receive 70% of the Trust assets. Further, each trust is to be funded with a pro rata portion of each asset held in Trust. The trustee then severs Trust 1 into three equal trusts, Trust GC1, Trust GC2, and Trust GC3. Each trust is named for a grandchild of T and provides that trust income is to be paid to S for life, and on S’s death, the trust is to terminate and the trust proceeds distributed to the respective grandchild for whom the trust is named. If that grandchild has predeceased the termination date, the trust proceeds are to be distributed to that grandchild’s then-living descendants, per stirpes, or, if none, to the other grandchildren (or their respective then-living descendants, per stirpes). Each trust is to be funded with a pro rata portion of each Trust 1 asset. The trustee also severs Trust 2 in a similar manner, into Trust GC1(2), Trust GC2(2), and Trust GC3(2). If the requirements of section 2642(a)(3) are otherwise satisfied, the severance of Trust into Trust 1 and Trust 2, the severance of Trust 1 into Trust GC1, Trust GC2, Trust GC3, and the severance of Trust 2 into Trust GC1(2), Trust GC2(2) and Trust GC3(2), constitute qualified severances. Trust GC1, Trust GC2, Trust GC3 will each have an inclusion ratio of zero and Trust GC1(2), Trust GC2(2) , and Trust GC3(2) will each have an inclusion ratio of one.

(f) Effective date. (1) This section applies to severances occurring on or after the date that this document is published in the Federal Register as final regulations.

(2) Transition rule. In the case of severances occurring after December 31, 2000, and before the date that this document is published in the Federal Register as a final regulation, taxpayers may rely on any reasonable interpretation of section 2642(a)(3) as long as reasonable notice concerning the severance and identification of the trusts involved has been given to the IRS. For this purpose, these proposed regulations are treated as a reasonable interpretation of the statute. For purposes of the notification requirement contained in §26.2642-6(b)(6), notification will be deemed timely if mailed by April 15th of the year immediately following the year during which the severance occurred or the last day of the period covered by an extension of time, if an extension of time is granted. For severances occurring between December 31, 2000, and January 1, 2004, notification will be deemed timely if mailed by November 22, 2004.

Par. 6. Section 26.2654-1 is amended as follows:

1. The paragraph heading for (b) and the introductory text of paragraph (b)(1) are revised.

2. Paragraph (c) is added.

The revision and addition reads as follows:

* * * * *

(b) Division of a trust included in the gross estate occurring on or before December 31, 2000—(1) In general. If a trust that is included in the transferor’s gross estate (or created under the transferor’s will) is severed on or before December 31, 2000, into two or more trusts, the severance is recognized for purposes of chapter 13 if—

* * * * *

(c) Qualified severance occurring after December 31, 2000. For rules applicable to the severance of a trust for GST tax purposes occurring after December 31, 2000, see §26.2642-6.

* * * * *

(b) LIFO inventory held indirectly through partnership. A C corporation must include the lookthrough LIFO recapture amount (as defined in paragraph (c)(2) of this section) in its gross income—

(1) In its last taxable year as a C corporation if, on the last day of the corporation’s last taxable year before its S corporation election becomes effective, the corporation held a lookthrough partnership interest (as defined in paragraph (c)(1) of this section); or

(2) In the year of transfer by the C corporation to an S corporation of a lookthrough partnership interest if the corporation transferred its lookthrough partnership interest to the S corporation in a nonrecognition transaction (within the meaning of section 7701(a)(45)) in which the transferred interest constitutes transferred basis property (within the meaning of section 7701(a)(43)).

(c) Definitions—(1) Lookthrough partnership interest. A partnership interest is a lookthrough partnership interest if the partnership owns (directly or indirectly through one or more partnerships) assets accounted for under the last-in, first-out (LIFO) method (LIFO inventory).

(2) Lookthrough LIFO recapture amount. For purposes of this section, a corporation’s lookthrough LIFO recapture amount is the amount of income that would be allocated to the corporation, taking into account section 704(c) and §1.704-3, if the partnership sold all of its LIFO inventory for the inventory’s FIFO value. For this purpose, the FIFO value of inventory is the inventory amount of the inventory assets under the first-in, first-out method of accounting authorized by section 471. The lookthrough LIFO recapture amount generally shall be determined as of the end of the recapture date. However, if the partnership is not otherwise required to determine the inventory amount of the inventory using the LIFO method (the LIFO value) on the recapture date, the partnership may determine the lookthrough LIFO recapture amount as though the FIFO and LIFO values of the inventory on the recapture date equaled the FIFO and LIFO values of the opening inventory for the partnership’s taxable year that includes the recapture date. For this purpose, the opening inventory includes inventory contributed by a partner to the partnership on or before the recapture date and excludes inventory distributed by the partnership to a partner on or before the recapture date.

(3) Recapture date. In the case of a transaction described in paragraph (b)(1) of this section, the recapture date is the day before the effective date of the S corporation election. In the case of a transaction described in paragraph (b)(2) of this section, the recapture date is the date of the transfer of the partnership interest to the S corporation (but only the portion of that date that precedes the transfer).

(d) Payment of tax. Any increase in tax caused by including the LIFO recapture amount or the lookthrough LIFO recapture amount in the gross income of the C corporation is payable in four equal installments. The C corporation must pay the first installment of this payment by the due date of its return, determined without regard to extensions, for the last taxable year it operated as a C corporation if paragraph (a)(1) or (b)(1) of this section applies, or for the taxable year of the transfer if paragraph (a)(2) or (b)(2) of this section applies. The three succeeding installments must be paid—

(1) For a transaction described in paragraph (a)(1) or (b)(1) of this section, by the corporation that made the election under section 1362(a) to be an S corporation, on or before the due date for the corporation’s returns (determined without regard to extensions) for the succeeding three taxable years; and

(2) For a transaction described in paragraph (a)(2) or (b)(2) of this section, by the transferee S corporation on or before the due date for the transferee corporation’s returns (determined without regard to extensions) for the succeeding three taxable years.

(e) Basis adjustments—(1) General rule. Appropriate adjustments to the basis of inventory are to be made to reflect any amount included in income under paragraph (a) of this section.

(2) LIFO inventory owned through a partnership—(i) Basis of corporation’s partnership interest. Appropriate adjustments to the basis of the corporation’s lookthrough partnership interest are to be made to reflect any amount included in income under paragraph (b) of this section.

(ii) Basis of partnership assets. A partnership directly holding LIFO inventory that is taken into account under paragraph (b) may elect to adjust the basis of that LIFO inventory. In addition, a partnership that holds, through another partnership, LIFO inventory that is taken into account under paragraph (b) may elect to adjust the basis of that partnership interest. Any adjustment under this paragraph (e)(2) to the basis of inventory held by the partnership is equal to the amount of LIFO recapture attributable to the inventory. Likewise, any adjustment under this paragraph (e)(2) to the basis of a lookthrough partnership interest held by the partnership is equal to the amount of LIFO recapture attributable to the interest. A basis adjustment under this paragraph (e)(2) is treated in the same manner and has the same effect as an adjustment to the basis of partnership property under section 743(b). See §1.743-1(j).

(3) Election. A partnership elects to adjust the basis of its inventory and any lookthrough partnership interest that it owns by attaching a statement to its original or amended income tax return for the first taxable year ending on or after the date of the S corporation election or transfer described in paragraph (b) of this section. This statement shall state that the partnership is electing under §1.1363-2(e)(3) and must include the names, addresses, and taxpayer identification numbers of any corporate partner liable for tax under paragraph (d) of this section and of the partnership, as well as the amount of the adjustment and the portion of the adjustment that is attributable to each pool of inventory or lookthrough partnership interest that is held by the partnership.

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

Example 1. (i) G is a C corporation with a taxable year ending on June 30. GH is a partnership with a calendar year taxable year. G has a 20 percent interest in GH. The remaining 80 percent interest is owned by an individual. On April 25, 2005, G contributed inventory that is LIFO inventory to GH, increasing G’s interest in the partnership to 50 percent. GH holds no other LIFO inventory. G elects to be an S corporation effective July 1, 2005. The recapture date is June 30, 2005, under paragraph (c)(3) of this section. GH determines that the FIFO and LIFO values of the opening inventory for GH’s 2005 taxable year, including the inventory contributed by G, are $200 and $120, respectively.

(ii) Under paragraph (c)(1) of this section, GH is not required to determine the FIFO and LIFO values of the inventory on the recapture date. Instead, GH may determine the lookthrough LIFO recapture amount as though the FIFO and LIFO values of the inventory on the recapture date equaled the FIFO and LIFO values of the opening inventory for the partnership’s taxable year (2005) that includes the recapture date. For this purpose, under paragraph (c)(2) of this section, the opening inventory includes the inventory contributed by G. The amount by which the FIFO value ($200) exceeds the LIFO value ($120) in GH’s opening inventory is $80. Thus, if GH sold all of its LIFO inventory for $200, it would recognize $80 of income. G’s lookthrough LIFO recapture amount is $80, the amount of income that would be allocated to G, taking into account section 704(c) and §1.704-3, if GH sold all of its LIFO inventory for the FIFO value. Under paragraph (b)(1) of this section, G must include $80 in income in its taxable year ending on June 30, 2005. Under paragraph (e)(2) of this section, G must increase its basis in its interest in GH by $80. Under paragraphs (e)(2) and (3) of this section, and in accordance with section 743(b) principles, GH may elect to increase the basis (with respect to G only) of its LIFO inventory by $80.

Example 2. (i) J is a C corporation with a calendar year taxable year. JK is a partnership with a calendar year taxable year. J has a 30 percent interest in the partnership. JK owns LIFO inventory that is not section 704(c) property. J elects to be an S corporation effective January 1, 2005. The recapture date is December 31, 2004, under paragraph (c)(3) of this section. JK determines that the FIFO and LIFO values of the inventory on December 31, 2004, are $240 and $140, respectively.

(ii) The amount by which the FIFO value ($240) exceeds the LIFO value ($140) on the recapture date is $100. Thus, if JK sold all of its LIFO inventory for $240, it would recognize $100 of income. J’s lookthrough LIFO recapture amount is $30, the amount of income that would be allocated to J if JK sold all of its LIFO inventory for the FIFO value (30 percent of $100). Under paragraph (b)(1) of this section, J must include $30 in income in its taxable year ending on December 31, 2004. Under paragraph (e)(2) of this section, J must increase its basis in its interest in JK by $30. Under paragraphs (e)(2) and (3) of this section, and in accordance with section 743(b) principles, JK may elect to increase the basis (with respect to J only) of its inventory by $30.

(g) Effective dates. * * *

(3) The provisions of paragraphs (b), (c), (e)(2), (e)(3), and (f) of this section apply to S elections and transfers made on or after August 13, 2004.

* * * * *

(d) [The text of the proposed amendment revising §301.7701-1(d) is the same as the text of §301.7701-1T(d) published elsewhere in this issue of the Bulletin.]

* * * * *

Par. 3. In §301.7701-2 paragraph (b)(9) is added to read as follows:

* * * * *

(b) * * *

(9) [The text of the proposed amendment adding §301.7701-2(b)(9) is the same as the text of §301.7701-2T(b)(9) published elsewhere in this issue of the Bulletin.]

* * * * *

Par. 4. Section 301.7701-5 is revised to read as follows:

[The text of the proposed amendment revising §301.7701-5 is the same as the text of §301.7701-5T published elsewhere in this issue of the Bulletin.]

* * * * *

(f) * * *

(2) Exception for certain conversions and refinancings. A partner is not subject to the minimum gain chargeback requirement to the extent the partner’s share of the net decrease in partnership minimum gain is caused by a recharacterization of nonrecourse partnership debt as partially or wholly recourse debt or partner nonrecourse debt, and the partner bears the economic risk of loss (within the meaning of §1.752-2) for the liability.

* * * * *

(g) * * *

(3) Conversions of recourse or partner nonrecourse debt into nonrecourse debt. A partner’s share of minimum gain is increased to the extent provided in this paragraph (g)(3) if a recourse or partner nonrecourse liability becomes partially or wholly nonrecourse. * * *

* * * * *

(i) * * *

(4) * * * A partner is not subject to this minimum gain chargeback, however, to the extent the net decrease in partner nonrecourse debt minimum gain arises because a partner nonrecourse liability becomes partially or wholly a nonrecourse liability. * * *

* * * * *

(l) * * * (1) * * *

(iv) Paragraph (f)(2), the first sentence of paragraph (g)(3), and the third sentence of paragraph (i)(4) of this section apply to liabilities incurred or assumed by a partnership on or after the date the regulations are published as final regulations in the Federal Register, other than liabilities incurred or assumed by a partnership pursuant to a written binding contract in effect prior to that date. Otherwise, the rules applicable to liabilities incurred or assumed (or subject to a binding contract in effect) prior to the date the regulations are published as final regulations in the Federal Register are contained in §1.704-2 in effect prior to the date the regulations are published as final regulations in the Federal Register, (see 26 CFR part 1 revised as of April 1, 2004).

* * * * *

Par. 3. Section 1.752-2 is amended as follows:

1. Paragraph (a) is revised.

2. The last sentence of paragraph (b)(6) is revised.

3. Paragraph (h)(3) is revised.

4. Paragraphs (k) and (l) are added.

The revisions and additions read as follows:

(a) In general. A partner’s share of a recourse partnership liability equals the portion of that liability, if any, for which the partner or related person bears the economic risk of loss. The determination of the extent to which a partner bears the economic risk of loss for a partnership liability is made under the rules in paragraphs (b) through (k) of this section.

(b) * * *

(6) * * * See paragraphs (j) and (k) of this section.

* * * * *

(h) * * *

(3) Valuation. The extent to which a partner bears the economic risk of loss for a partnership liability as a result of a direct pledge described in paragraph (h)(1) of this section or an indirect pledge described in paragraph (h)(2) of this section is limited to the net fair market value of the property at the time of the pledge or contribution. For purposes of this paragraph, if property is subject to one or more other obligations that are senior or of equal priority to the partnership liability, those obligations must be taken into account in determining the net fair market value of pledged property.

* * * * *

(k) Effect of a disregarded entity—(1) In general. In determining the extent to which a partner bears the economic risk of loss for a partnership liability, obligations of a business entity that is disregarded as an entity separate from its owner under sections 856(i) or 1361(b)(3) or §§301.7701-1 through 301.7701-3 of this chapter (disregarded entity), that may be taken into account under paragraph (b)(1) of this section, are taken into account only to the extent of the net value of the disregarded entity (as determined under paragraph (k)(2) of this section) as of the date on which the partnership determines the partner’s share of partnership liabilities pursuant to §§1.752-4(d) and 1.705-1(a) that is allocated to the liability under paragraph (k)(4) of this section. The rules of this paragraph (k) do not apply to an obligation of a disregarded entity to the extent that the owner of the disregarded entity otherwise is required to make a payment (that satisfies the requirements of paragraph (b)(1) of this section) with respect to such obligation of the disregarded entity.

(2) Net value of a disregarded entity. For purposes of paragraph (k)(1) of this section, the net value of a disregarded entity equals the fair market value of all assets owned by the entity that may be subject to creditors’ claims under local law, including the entity’s enforceable rights to contributions from its owner but excluding the entity’s interest in the partnership (if any) and the fair market value of property pledged to secure a partnership liability under paragraph (h)(1) of this section, less obligations of the disregarded entity that do not constitute, and are senior or of equal priority to, obligations of the disregarded entity that may be taken into account under paragraph (b)(1) of this section. After the net value of a disregarded entity is initially determined for purposes of paragraph (k)(1) of this section, the net value of the disregarded entity is not redetermined unless the obligations of the disregarded entity that are described in the preceding sentence change by more than a de minimis amount or there is more than a de minimis contribution to or distribution from the disregarded entity of property other than property pledged to secure a partnership liability under paragraph (h)(1) of this section.

(3) Reduction in net value of a disregarded entity. For purposes of paragraph (k)(2) of this section, the net value of a disregarded entity is determined by taking into account a subsequent reduction in the net value of the disregarded entity if at the time the net value of the disregarded entity is determined it is anticipated that the net value of the disregarded entity will subsequently be reduced and the reduction is part of a plan that has as one of its principal purposes creating the appearance that a partner bears the economic risk of loss for a partnership liability.

(4) Allocation of net value. If one or more disregarded entities have obligations that may be taken into account under paragraph (b)(1) of this section with respect to one or more partnership liabilities, or liabilities of more than one partnership, the partnership must allocate the net value of each disregarded entity among partnership liabilities in a reasonable and consistent manner, taking into account priorities among partnership liabilities.

(5) Information to be provided by the owner of a disregarded entity. A partner that may be treated as bearing the economic risk of loss for a partnership liability based upon an obligation of a disregarded entity that may be taken in account under paragraph (b)(1) of this section must provide information as to the entity’s tax classification and net value to the partnership on a timely basis.

(6) The following examples illustrate the rules of this paragraph (k):

Example 1. Disregarded entity with net value of zero. (i) In 2005, A forms a wholly owned domestic limited liability company, LLC, with a contribution of $100,000. A has no liability for LLC’s debts, and LLC has no enforceable right to contribution from A. A files no election with respect to LLC under §301.7701-3 of this chapter. Also in 2005, LLC contributes $100,000 to LP, a limited partnership with a calendar year taxable year, in exchange for a general partnership interest in LP, and B and C each contributes $100,000 to LP in exchange for a limited partnership interest in LP. The partnership agreement provides that only LLC is required to make up any deficit in its capital account. On January 1, 2006, LP borrows $300,000 from a bank and uses $600,000 to purchase nondepreciable property. The $300,000 debt is secured by the property and is also a general obligation of LP. LP makes payments of only interest on its $300,000 debt during 2006. Under §§1.752-4(d) and 1.705-1(a), LP determines its partners’ shares of the $300,000 debt at the end of its taxable year, December 31, 2006. As of that date, LLC holds no assets other than its interest in LP.

(ii) Under §301.7701-3(b)(1)(ii) of this chapter, LLC is a disregarded entity. Because LLC is a disregarded entity, A is treated as the partner in LP for federal tax purposes. Only LLC has an obligation to make a payment on account of the $300,000 debt if LP were to constructively liquidate as described in paragraph (b)(1) of this section. Therefore, under paragraph (k) of this section, A is treated as bearing the economic risk of loss for LP’s $300,000 debt only to the extent of LLC’s net value. Because that net value is $0 on December 31, 2006, when LP determines its partners’ shares of its $300,000 debt, A is not treated as bearing the economic risk of loss for any portion of LP’s $300,000 debt. As a result, LP’s $300,000 debt is characterized as nonrecourse under §1.752-1(a) and is allocated as required by §1.752-3.

Example 2. Disregarded entity with positive net value. (i) The facts are the same as in Example 1 except that on January 1, 2007, A contributes $250,000 to LLC and LLC shortly thereafter uses the $250,000 to purchase unimproved land. LP makes payments of only interest on its $300,000 debt during 2007. Under §§1.752-4(d) and 1.705-1(a), LP again determines its partners’ shares of the $300,000 debt at the end of its taxable year, December 31, 2007. As of that date, LLC holds its interest in LP and the land, the value of which has declined to $175,000.

(ii) A’s contribution of $250,000 to LLC on January 1, 2007, constitutes a more than de minimis contribution of property to LLC. Accordingly, under paragraph (k)(2) of this section, LLC’s value is redetermined on December 31, 2007, when LP determines its partners’ shares of its $300,000 debt. As of that date, LLC’s net value is $175,000. Therefore, under paragraph (k) of this section, A is treated as bearing the economic risk of loss for $175,000 of LP’s $300,000 debt. As a result, $175,000 of LP’s $300,000 debt is recharacterized as recourse under §1.752-1(a) and is allocated to A under this section, and the remaining $125,000 of LP’s $300,000 debt remains characterized as nonrecourse under §1.752-1(a) and is allocated as required by §1.752-3.

Example 3. Allocation of net value among partnership liabilities. (i) The facts are the same as in Example 2 except that on January 1, 2008, A forms another wholly owned domestic limited liability company, LLC2, with a contribution of $120,000. Shortly thereafter, LLC2 uses the $120,000 to purchase stock in X corporation. A has no liability for LLC2’s debts, and LLC2 has no enforceable right to contribution from A. A files no election with respect to LLC2 under §301.7701-3 of this chapter. On July 1, 2008, LP borrows $100,000 from a bank and uses the $100,000 to purchase nondepreciable property. The $100,000 debt is secured by the property and is also a general obligation of LP. The $100,000 debt is senior in priority to LP’s existing $300,000 debt. Also on July 1, 2008, LLC2 agrees to guarantee both LP’s $100,000 and $300,000 debts. LP makes payments of only interest on both its $100,000 and $300,000 debts during 2008. Under §§1.752-4(d) and 1.705-1(a), LP determines its partners’ shares of its $100,000 and $300,000 debts at the end of its taxable year, December 31, 2008. As of that date, LLC holds its interest in LP and the land, and LLC2 holds the X corporation stock which has appreciated in value to $140,000.

(ii) Under §301.7701-3(b)(1)(ii) of this chapter, LLC2 is a disregarded entity. Both LLC and LLC2 have obligations to make a payment on account of LP’s debts if LP were to constructively liquidate as described in paragraph (b)(1) of this section. Therefore, under paragraph (k) of this section, A is treated as bearing the economic risk of loss for LP’s $100,000 and $300,000 debts only to the extent of the net values of LLC and LLC2, as allocated among those debts in a reasonable manner pursuant to paragraph (k)(4) of this section.

(iii) No events have occurred that would allow a revaluation under paragraph (k)(2) of this section. Therefore, LLC’s net value remains $175,000. LLC2’s net value on December 31, 2008, when LP determines its partners’ shares of its liabilities, is $140,000. Under paragraph (k)(4) of this section, LP must allocate the net values of LLC and LLC2 between its $100,000 and $300,000 debts in a reasonable and consistent manner. Because the $100,000 debt is senior in priority to the $300,000 debt, LP first allocates the net values of LLC and LLC2, pro rata, to its $100,000 debt. Thus, LP allocates $56,000 of LLC’s net value and $44,000 of LLC2’s net value to its $100,000 debt, and A is treated as bearing the economic risk of loss for all of LP’s $100,000 debt. As a result, all of LP’s $100,000 debt is characterized as recourse under §1.752-1(a) and is allocated to A under this section. LP then allocates the remaining $119,000 of LLC’s net value and LLC2’s $96,000 net value to its $300,000 debt, and A is treated as bearing the economic risk of loss for a total of $215,000 of the $300,000 debt. As a result, $215,000 of LP’s $300,000 debt is characterized as recourse under §1.752-1(a) and is allocated to A under this section, and the remaining $85,000 of LP’s $300,000 debt is characterized as nonrecourse under §1.752-1(a) and is allocated as required by §1.752-3. This example illustrates one reasonable method for allocating net values of disregarded entities among multiple partnership liabilities.

(l) Effective dates. Paragraphs (a), (b)(6), (h)(3), and (k) of this section apply to liabilities incurred or assumed by a partnership on or after the date the regulations are published as final regulations in the Federal Register, other than liabilities incurred or assumed by a partnership pursuant to a written binding contract in effect prior to that date.Otherwise, the rules applicable to liabilities incurred or assumed (or subject to a binding contract in effect) prior to the date the regulations are published as final regulations in the Federal Register are contained in §§1.752-2 and 1.752-3 in effect prior to the date the regulations are published as final regulations in the Federal Register, (see 26 CFR part 1 revised as of April 1, 2004).

These proposed regulations provide that a transaction otherwise qualifying as a reorganization under section 368(a) will not be disqualified as a result of a subsequent distribution of the acquired assets or stock if (i) no transferee receives substantially all of the acquired assets, substantially all of the assets of the acquired or surviving corporation in a transaction otherwise qualifying as a reorganization under section 368(a)(1)(B) or section 368(a)(1)(A) by reason of section 368(a)(2)(E), or stock constituting control of the acquired corporation, (ii) the transferee is either a member of the qualified group (as defined in §1.368-1(d)(4)(ii)) or a partnership the business of which is treated as conducted by a member of the qualified group under §1.368-1(d)(4)(iii), and (iii) the COBE requirement is satisfied. For this purpose, the term substantially all as used in this regulation has the same meaning as in section 368(a)(1)(C). The IRS and Treasury Department believe that the types of asset and stock distributions described in these proposed regulations are consistent with the policies underlying the reorganization provisions, which are intended to apply to transactions that effect readjustments of continuing interests in the reorganized business in modified corporate form. See §1.368-1(b); see also H.R. Rep. No. 83-1337, at A134 (1954) (stating that a corporation may not acquire assets with the intention of transferring them to a stranger).

In the course of developing these proposed regulations, the IRS and Treasury Department considered adopting a rule that would permit a distribution of the acquiring, acquired, or surviving corporation’s assets as long as the distribution did not cause that corporation to be treated as liquidating for Federal income tax purposes. However, the IRS and Treasury Department are concerned that such a rule might produce inappropriate results. For example, if a pre-existing acquiring subsidiary in a transaction otherwise qualifying under section 368(a) by reason of section 368(a)(2)(D) distributes all of the acquired assets to the issuing corporation and retains all of the previously held assets, the distribution may not constitute either an actual or de facto liquidation, even though none of the acquired assets remain in the acquiring corporation. It could be argued that this transaction should be treated as a direct acquisition of the acquired assets by the issuing corporation. See, e.g., Rev. Rul. 72-405, 1972-2 C.B. 217.

The IRS and Treasury Department request comments regarding whether a transaction should continue to qualify as a reorganization under section 368(a) if the distribution, including a distribution to which section 355 applies, is to a person that is not a member of the qualified group (as defined in §1.368-1(d)(4)(ii)) or a partnership the business of which is not treated as conducted by a member of the qualified group under §1.368-1(d)(4)(iii).

Currently, the operative rules of §1.368-2(k) are silent on the effect of a post-transaction transfer of assets or stock to a partnership on a transaction otherwise qualifying as a reorganization. However, Example 3 of that regulation involves a transfer of acquired stock to a partnership. In the example, P owns 80 percent of the stock of S-1, S-1 owns 80 percent of the stock of S-2, and S-2 owns 80 percent of the stock of S-3. Pursuant to a plan of reorganization, S-1 acquires the stock of T solely in exchange for P voting stock, S-1 transfers the T stock to S-2, and S-2 transfers the T stock to S-3. Also as part of the plan, S-2 and S-3 form PRS, a partnership, and S-3 transfers the T stock to PRS in exchange for an 80 percent partnership interest. The example states that because this transfer to PRS is not described in §1.368-2(k), the characterization of the transaction must be determined under the relevant provisions of law, including the step transaction doctrine. The transaction therefore fails to qualify as a reorganization under section 368(a)(1)(B) because the acquiring corporation does not have control of T immediately after the acquisition.

The IRS and Treasury Department are studying whether, in the transaction described in Example 3 of the current §1.368-2(k), S-1 should be treated as having control of T immediately after the acquisition. Consequently, Example 3 is not included in these proposed regulations. However, the IRS and Treasury Department recognize that certain transfers to partnerships would cause a transaction to fail the COBE requirement. For example, under the facts of Example 3 of the current §1.368-2(k), because T is not a member of the qualified group after the stock transfer to PRS, the transaction would not satisfy the COBE requirement. Comments are requested on whether and how the COBE regulations should be amended to permit stock transfers to partnerships.

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

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(d) * * *

(4) * * *

(i) Business and assets of members of a qualified group—(A) In general. * * *

(B) Special rule. The issuing corporation is treated as holding all of the businesses and assets of the surviving corporation after a reorganization that otherwise satisfies the requirements of a reverse triangular merger (as defined in §1.358-6(b)(2)(iii)), the acquired corporation after a reorganization that otherwise satisfies the requirements of section 368(a)(1)(B), and the acquiring corporation after a reorganization that otherwise satisfies the requirements of a forward triangular merger (as defined in §1.358-6(b)(2)(i)), a triangular B reorganization (as defined in §1.358-6(b)(2)(iv)), a triangular C reorganization (as defined in §1.358-6(b)(2)(ii)), or a reorganization under section 368(a)(1)(G) by reason of section (a)(2)(D), provided that members of the qualified group own, in the aggregate, stock of the surviving, acquired, or acquiring corporation meeting the requirements of section 368(c). This paragraph (d)(4)(i)(B) applies to transactions occurring after the date these regulations are published as final in the Federal Register.

* * * * *

(5) Examples. (i) The following examples illustrate this paragraph (d). All the corporations have only one class of stock outstanding:

* * * * *

Example 7. (i) Facts. The facts are the same as Example 6, except that, instead of P acquiring the assets of T, HC acquires all of the outstanding stock of T in exchange solely for voting stock of P. In addition, as part of the plan of reorganization, HC transfers 10 percent of the stock of T to each of subsidiaries S-1 through S-10. T will continue to operate an auto parts distributorship. Without regard to whether the transaction satisfies the COBE requirement, the transaction qualifies as a triangular B reorganization.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(i)(B) of this section, P is treated as holding the assets and conducting the business of T because S-1 through S-10, members of the qualified group, together own stock of T meeting the requirements of section 368(c). The COBE requirement of paragraph (d)(1) of this section is satisfied because P is treated as continuing T’s business.

* * * * *

Example 9. * * * (i) Facts. The facts are the same as Example 8, except that S-3 transfers the historic T business to PRS in exchange for a 1 percent interest in PRS.

(ii) * * *

Example 10. * * * (i) Facts. The facts are the same as Example 8, except that S-3 transfers the historic T business to PRS in exchange for a 33¹/₃ percent interest in PRS, and no member of P’s qualified group performs active and substantial management functions for the ski boot business operated in PRS.

* * * * *

Example 12. * * * (i) Facts. The facts are the same as Example 11, except that S-1 transfers all the T assets to PRS, and P and X each transfers cash to PRS in exchange for partnership interests. * * *

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(ii) Effective dates. Paragraph (d)(5) Example 6 and Example 8 through Example 13 apply to transactions occurring after January 28, 1998, except that they do not apply to any transaction occurring pursuant to a written agreement that is binding on January 28, 1998, and at all times thereafter. Paragraph (d)(5) Example 7 applies to transactions occurring after the date these regulations are published as final regulations in the Federal Register.

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Par. 3. Section 1.368-2 is amended by:

1. Adding three sentences at the end of paragraph (f).

2. Revising paragraphs (j)(3)(ii) and (iv).

3. Removing the first sentence of paragraph (j)(3)(iii) and adding two new sentences.

4. Revising paragraph (k).

The additions and the revision read as follows:

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(f) * * * If a transaction otherwise qualifies as a reorganization under section 368(a)(1)(B) or as a reverse triangular merger (as defined in §1.358-6(b)(2)(iii)), the target corporation (in the case of a transaction that otherwise qualifies as a reorganization under section 368(a)(1)(B)) or the surviving corporation (in the case of a transaction that otherwise qualifies as a reverse triangular merger) remains a party to the reorganization even though its stock or assets are transferred in a transaction described in paragraph (k) of this section. If a transaction otherwise qualifies as a forward triangular merger (as defined in §1.358-6(b)(2)(i)), a triangular B reorganization (as defined in §1.358-6(b)(2)(iv)), a triangular C reorganization (as defined in §1.358-6(b)(2)(ii)), or a reorganization under section 368(a)(1)(G) by reason of section 368(a)(2)(D), the acquiring corporation remains a party to the reorganization even though its stock is transferred in a transaction described in paragraph (k) of this section. The two preceding sentences apply to transactions occurring after the date these regulations are published as final regulations in the Federal Register.

* * * * *

(j) * * *

(3) * * *

(ii) Except as provided in paragraph (k) of this section, the controlling corporation must control the surviving corporation immediately after the transaction.

(iii) After the transaction, the surviving corporation must hold substantially all of its own properties and substantially all of the properties of the merged corporation (other than stock of the controlling corporation distributed in the transaction). The issuing corporation may transfer such properties as provided in paragraph (k) of this section. * * *

* * * * *

(iv) Paragraph (j)(3)(ii) and the first two sentences of paragraph (j)(3)(iii) of this section apply to transactions occurring after the date these regulations are published as final regulations in the Federal Register. The remainder of paragraph (j)(3)(iii) of this section applies to transactions occurring after January 28, 1998, except that it does not apply to any transaction occurring pursuant to a written agreement which is binding on January 28, 1998, and at all times thereafter.

* * * * *

(k) Certain transfers of assets or stock in reorganizations—(1) General rule. A transaction otherwise qualifying as a reorganization under section 368(a) shall not be disqualified as a result of a subsequent transfer (or successive transfers) of assets or stock if—

(i) The transfer is of part or all of—

(A) The assets of any party to the reorganization; or

(B) The stock of any party to the reorganization other than the issuing corporation (as defined in §1.368-1(b)); and

(ii) Either—

(A) In such subsequent transfer or transfers, a person is not the transferee of—

(1) substantially all (within the meaning of section 368(a)(1)(C)) of the acquired assets;

(2) substantially all (within the meaning of section 368(a)(1)(C)) of the assets of the acquired corporation immediately after a transaction otherwise qualifying as a reorganization under section 368(a)(1)(B);

(3) substantially all (within the meaning of section 368(a)(1)(C)) of the assets of the surviving corporation immediately after a transaction otherwise qualifying as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(E); or

(4) control of the stock of the acquired corporation; or

(B) The transfer is to one or more corporations controlled in each transfer by the transferor corporation or to a partnership in which the transferor has an ownership interest immediately after the transfer; and

(iii) The transferee is either a member of the qualified group (as defined in §1.368-1(d)(4)(ii)) or a partnership the business of which is treated as conducted by a member of the qualified group under §1.368-1(d)(4)(iii); and

(iv) The requirements of §1.368-1(d) are satisfied.

(2) Control is defined under section 368(c).

(3) Examples. The following examples illustrate the application of this paragraph (k). Except as otherwise noted, P is the issuing corporation, and T is the target corporation. T operates a bakery that supplies delectable pastries and cookies to local retail stores. The acquiring corporate group produces a variety of baked goods for nationwide distribution. P owns 80 percent of the stock of S-1 and 80 percent of the stock of S-4. S-1 owns 80 percent of the stock of S-2. S-2 owns 80 percent of the stock of S-3, which also makes and supplies pastries and cookies. S-4 owns 80 percent of the stock of S-5. The examples are as follows:

Example 1. Contributions of acquired assets to controlled corporations after a reorganization under section 368(a)(1)(C). (i) Facts. Pursuant to a plan of reorganization, T transfers all of its assets to S-1 solely in exchange for P stock, which T distributes to its shareholders. In addition, pursuant to the plan of reorganization, S-1 transfers all of the T assets to S-2, and S-2 transfers all of the T assets to S-3.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(C), is not disqualified by the successive transfers of all of the T assets to S-2 and from S-2 to S-3 because, in each transfer, the transferee corporation is controlled by the transferor corporation, S-2 and S-3 are members of the qualified group, and the transaction satisfies the requirements of §1.368-1(d).

Example 2. Distribution of acquired assets to the issuing corporation after a reorganization under section 368(a)(1)(C). (i) Facts. Pursuant to a plan of reorganization, T transfers all of its assets to S-1 solely in exchange for P stock, which T distributes to its shareholders. In addition, pursuant to the plan of reorganization, S-1 transfers less than substantially all of the T assets to P. T does not have any liabilities.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(C), is not disqualified by the transfer of T assets from S-1 to P because P is transferred less than substantially all of the T assets, P is a member of the qualified group, and the transaction satisfies the requirements of §1.368-1(d).

Example 3. Contributions of acquired assets to controlled corporations after a reorganization under section 368(a)(1)(D). (i) Facts. P owns 100 percent of the stock of T. Pursuant to a plan of reorganization, T transfers all of its assets to S-1 solely in exchange for S-1 stock, which T distributes to P. In addition, pursuant to the plan of reorganization, S-1 transfers all of the T assets to S-2, and S-2 transfers all of the T assets to S-3.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(D), is not disqualified by the successive transfers of all the acquired assets from S-1 to S-2 and from S-2 to S-3 because, in each transfer, the transferee corporation is controlled by the transferor corporation, S-2 and S-3 are members of the qualified group, and the transaction satisfies the requirements of §1.368-1(d).

Example 4. Contribution of acquiring stock to controlled corporation after a reorganization under section 368(a)(1)(A). (i) Facts. Pursuant to a plan of reorganization, S-1 acquires all of the T assets in the merger of T into S-1. In the merger, the T shareholders receive consideration 50 percent of which is P stock and 50 percent of which is cash. Also, pursuant to the plan of reorganization, P transfers all of the S-1 stock to S-4.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(D), is not disqualified by the transfer of all of the S-1 stock to S-4 because the transferee corporation is controlled by the transferor corporation, S-4 is a member of the qualified group, and the transaction satisfies the requirements of §1.368-1(d).

Example 5. Contribution of acquired assets to a partnership after a reorganization under section 368(a)(1)(A). (i) Facts. Pursuant to a plan of reorganization, S-1 acquires all of the T assets in the merger of T into S-1. In the merger, the T shareholders receive consideration 50 percent of which is P stock and 50 percent of which is cash. In addition, pursuant to the plan of reorganization, S-1 transfers all of the T assets to PRS, a partnership in which S-1 owns a 33¹/₃ percent interest. S-1 does not perform active and substantial management functions as a partner with respect to PRS’ business.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(D), is not disqualified by the transfer of T assets from S-1 to PRS because S-1 has an ownership interest in PRS immediately after the transfer, S-1 is a member of the qualified group and is treated as conducting the business of PRS under §1.368-1(d)(4)(iii), and the transaction satisfies the requirements of §1.368-1(d).

Example 6. Distribution of acquired assets to a partnership after a reorganization under section 368(a)(1)(A). (i) Facts. P owns an 80 percent interest in PRS, a partnership. PRS owns 20 percent of the stock of S-1. Pursuant to a plan of reorganization, S-1 acquires all of the T assets in the merger of T into S-1. In the merger, the T shareholders receive consideration 50 percent of which is P stock and 50 percent of which is cash. In addition, pursuant to the plan of reorganization, S-1 distributes less than substantially all of the T assets to PRS in redemption of 5 percent of the stock of S-1 owned by PRS.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(D), is not disqualified by the transfer of T assets from S-1 to PRS because PRS receives less than substantially all of the T assets, P is a member of the qualified group and is treated as conducting the business of PRS under §1.368-1(d)(4)(iii), and the transaction satisfies the requirements of §1.368-1(d).

Example 7. Contributions of acquired stock to controlled corporations after a reorganization under section 368(a)(1)(B). (i) Facts. Pursuant to a plan of reorganization, the T shareholders transfer all of their T stock to S-1 solely in exchange for P stock. In addition, pursuant to the plan of reorganization, S-1 transfers 50 percent of the T stock to S-2, and S-2 transfers that T stock to S-3.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(B), is not disqualified by the successive transfers of part of the acquired stock from S-1 to S-2, and from S-2 to S-3 because, in each transfer, the transferee corporation is controlled by the transferor corporation, S-2 and S-3 are members of the qualified group, and the transaction satisfies the requirements of §1.368-1(d).

Example 8. Contributions of acquiring corporation stock to controlled corporations after a reorganization under section 368(a)(1)(B). (i) Facts. Pursuant to a plan of reorganization, the T shareholders transfer all of their T stock to S-1 solely in exchange for P stock. In addition, as part of the plan of reorganization, following the acquisition of T stock by S-1, P transfers 10 percent of the S-1 stock to S-4, and S-4 transfers that S-1 stock to S-5.

(ii) Analysis. Under this paragraph (k), the transaction, which otherwise qualifies as a reorganization under section 368(a)(1)(B), is not disqualified by the successive transfers of S-1 stock to S-4 and from S-4 to S-5 because, in each transfer, the transferee corporation is controlled by the transferor corporation, S-4 and S-5 are members of the qualified group, and the transaction satisfies the requirements of §1.368-1(d).

(4) Effective date. This paragraph (k) applies to transactions occurring after the date these regulations are published as final regulations in the Federal Register.