Determination of Basis of Stock or Securities Received in Exchange for, or With Respect to, Stock or Securities in Certain Transactions; Treatment of Excess Loss Accounts, 4264-4276 [06-585]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 17 (Thursday, January 26, 2006)]
[Rules and Regulations]
[Pages 4264-4276]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-585]



[[Page 4264]]

-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9244]
RIN 1545-BC05; 1545-BE88


Determination of Basis of Stock or Securities Received in 
Exchange for, or With Respect to, Stock or Securities in Certain 
Transactions; Treatment of Excess Loss Accounts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations under section 358 
that provide guidance regarding the determination of the basis of stock 
or securities received in exchange for, or with respect to, stock or 
securities in certain transactions. This document also contains 
temporary regulations under section 1502 that govern certain basis 
determinations and adjustments of subsidiary stock in certain 
transactions involving members of a consolidated group. The text of the 
temporary regulations also serves as the text of the proposed 
regulations set forth in the notice of proposed rulemaking on this 
subject in the Proposed Rules section in this issue of the Federal 
Register. The final and temporary regulations affect shareholders of 
corporations.

DATES: Effective Date: The final and temporary regulations are 
effective on January 23, 2006.
    Applicability Dates: Section 1.1502-19T applies to adjustments and 
determinations of basis of (including an excess loss account in) the 
stock of a member occurring on or after January 23, 2006. The 
applicability of Sec. 1.1502-19T will expire on January 23, 2009.

FOR FURTHER INFORMATION CONTACT: Theresa M. Kolish, (202) 622-7530 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    Section 358(a)(1) of the Internal Revenue Code (Code) generally 
provides that the basis of property received pursuant to an exchange to 
which section 351, 354, 355, 356, or 361 applies is the same as that of 
the property exchanged, decreased by the fair market value of any other 
property (except money) received by the taxpayer, the amount of any 
money received by the taxpayer, and the amount of loss to the taxpayer 
which was recognized on such exchange, and increased by the amount 
which was treated as a dividend, and the amount of gain to the taxpayer 
which was recognized on such exchange (not including any portion of 
such gain which was treated as a dividend). Section 358(b)(1) provides 
that, under regulations prescribed by the Secretary, the basis 
determined under section 358(a)(1) must be allocated among the 
properties received in the exchange or distribution.
    On May 3, 2004, the IRS and Treasury Department published a notice 
of proposed rulemaking (REG-116564-03) in the Federal Register (69 FR 
24107) that included regulations under section 358 (the proposed 
regulations) providing guidance regarding the determination of the 
basis of shares or securities received in a reorganization described in 
section 368 and a distribution to which section 355 applies. The 
proposed regulations adopt a tracing method pursuant to which the basis 
of each share of stock or security received in a reorganization under 
section 368 is traced to the basis of each surrendered share of stock 
or security, and each share of stock or security received in a 
distribution under section 355 is allocated basis from a share of stock 
or security of the distributing corporation. In the course of 
developing the proposed regulations, the IRS and Treasury Department 
considered whether a tracing method or an averaging method should be 
used to determine the basis of stock and securities received in such 
transactions. The proposed regulations' adoption of the tracing method 
is based on the view of the IRS and Treasury Department that, in light 
of the carryover basis rule of section 358, a reorganization is not an 
event that justifies averaging the bases of exchanged stock or 
securities that have been purchased at different times and at different 
prices. Moreover, the adoption of the tracing method reflects the 
concern of the IRS and Treasury Department that averaging the bases of 
exchanged blocks of stock or securities may inappropriately limit the 
ability of taxpayers to arrange their affairs and may afford 
opportunities for the avoidance of certain provisions of the Code.
    Under the proposed regulations, the basis of each share of stock or 
security received in an exchange to which section 354, 355, or 356 
applies is generally the same as the basis of the share or shares of 
stock or security or securities exchanged therefor. In the case of a 
distribution to which section 355 applies, the proposed regulations 
provide that the basis of each share of stock or security of the 
distributing corporation is allocated between the share of stock or 
security of the distributing corporation and the share of stock or 
security received with respect to such share of stock or security of 
the distributing corporation in proportion to their fair market values.
    If a shareholder or security holder is unable to identify which 
particular share (or portion of a share) of stock or security is 
exchanged for, or received with respect to, a particular share (or 
portion of a share) of stock or security, the proposed regulations 
permit the shareholder or security holder to designate which share or 
security is received in exchange for, or in respect of, which share or 
security. Such designation, however, must be consistent with the terms 
of the exchange or distribution and must be made on or before the first 
date on which the basis of a share or security received is relevant, 
for example, the date on which a share or security received is sold, or 
is transferred in an exchange described in section 351 or section 721 
or a reorganization described in section 368.
    No public hearing regarding the proposed regulations was requested 
or held. However, several written and electronic comments regarding the 
proposed regulations were received. After consideration of the 
comments, the proposed regulations are adopted as amended by this 
Treasury decision.

Explanation of Provisions

    These final regulations retain the tracing method of the proposed 
regulations, but make several modifications to the proposed regulations 
in response to the comments received. The following paragraphs describe 
the most significant comments received and the extent to which they 
have been incorporated into these final and temporary regulations.

A. Allocation of Consideration Received

    As described above, in certain cases, the proposed regulations 
permit a shareholder to designate which share or security is received 
in exchange for, or with respect to, which share or security, provided 
that the designation is consistent with the terms of the exchange or 
distribution. One commentator observed that in certain cases in which 
more than one class of stock or securities is received in exchange for 
more than one block of stock, more than one designation may be 
consistent with the terms of the exchange. For example, suppose that A 
owns two blocks of 100 shares of Corporation X common stock. Each block 
has a value of $100. A has an

[[Page 4265]]

aggregate basis of $50 in one block and an aggregate basis of $250 in 
the other block. Pursuant to the terms of a reorganization, A transfers 
both blocks in exchange for 100 shares of Corporation Y common stock 
with a value of $100 and 100 shares of Corporation Y preferred stock 
with a value of $100. Under the proposed regulations, A's designation 
could reflect that each of the Corporation Y common stock and the 
Corporation Y preferred stock are allocated to the shares exchanged in 
proportion to their fair market values. Therefore, Corporation Y common 
stock with a fair market value of $50 and Corporation Y preferred stock 
with a fair market value of $50 would be treated as received for each 
block of Corporation X common stock. Alternatively, A's designation 
could reflect that the low basis Corporation X shares were exchanged 
for Corporation Y common stock and the high basis Corporation X shares 
were exchanged for Corporation Y preferred stock or vice versa. Other 
designations would also seemingly be permitted under the proposed 
regulations. The commentator requested clarification regarding whether 
these designations would, in fact, be permitted.
    The IRS and Treasury Department have considered the extent to which 
taxpayers should be permitted to designate which type of consideration 
is received in exchange for particular shares of stock or securities 
when more than one designation is consistent with the terms of the 
exchange. The IRS and Treasury Department believe that this issue is 
likely to arise only in cases in which the target corporation is 
closely held. In these cases, the shareholders will likely have the 
ability to control the terms of the exchange. These final regulations 
confirm that, to the extent the terms of the exchange specify which 
shares of stock or securities are received in exchange for a particular 
share of stock or security or a particular class of stock or 
securities, provided that such terms are economically reasonable, such 
terms will control for purposes of determining the basis of the stock 
or securities received. In addition, these final regulations provide 
that, to the extent the terms of the exchange do not specify which 
shares of stock or securities are received in exchange for a particular 
share of stock or security or a particular class of stock or 
securities, a pro rata portion of the shares of stock and securities of 
each class received is treated as received in exchange for each share 
of stock and security surrendered, based on the fair market value of 
the surrendered stock and securities. The final regulations also 
include similar rules that apply to distributions under section 355.

B. Allocation of Boot Received

    A number of commentators requested guidance regarding the proper 
method for allocating boot among the stock and securities surrendered 
in an exchange or the stock and securities with respect to which a 
distribution is made. An allocation of boot may be necessary to compute 
the taxpayer's gain recognized in connection with a transaction and, 
therefore, its basis in stock and securities received. One commentator 
suggested that a facts and circumstances analysis (presumably one that 
examines the terms of the exchange) should be used to determine what 
nonrecognition property received in an exchange is allocable to 
particular shares or securities surrendered. In cases in which the 
facts and circumstances do not suggest a particular allocation, the 
commentator suggested that the boot should be allocated pro rata among 
the surrendered stock and securities. For example, suppose A holds 100 
shares of Corporation T common stock and 100 shares of Corporation T 
preferred stock. The common shares have an aggregate basis of $10 and 
an aggregate fair market value of $100 and the preferred shares have an 
aggregate basis of $20 and an aggregate fair market value of $100. 
Corporation T merges with and into Corporation X in a reorganization 
under section 368. In the reorganization, A exchanges its shares of 
Corporation T common and preferred stock for 100 shares of Corporation 
X common stock with an aggregate fair market value of $100 and $100 of 
cash. If the cash were allocated proportionately between the common and 
preferred shares based on their relative values, A would recognize $50 
of gain on its common shares and $50 of gain on its preferred shares. 
If the cash were allocated solely to the common shares, A would 
recognize $90 of gain. If the cash were allocated solely to the 
preferred shares, A would recognize $80 of gain.
    These final regulations adopt rules governing the allocation of 
boot among stock and securities surrendered (or with respect to which a 
distribution is made) that are consistent with those rules described 
above regarding designations of exchanges and distributions when more 
than one class of stock or securities is received in exchange for, or 
received with respect to, more than one block of stock. In particular, 
this Treasury decision includes regulations under section 356 that 
provide that, for purposes of computing the gain, if any, recognized on 
an exchange, to the extent the terms of the exchange specify the other 
property or money that is received in exchange for a particular share 
of stock or security surrendered, provided that such terms are 
economically reasonable, such terms control. This position is 
consistent with the conclusions reached in Revenue Ruling 74-515, 1974-
2 C.B. 118 (suggesting that, for purposes of computing gain recognized 
under section 356 in the context of an exchange the terms of which 
provided for the exchange of common stock for common stock and 
preferred stock for cash, the terms of the exchange governed). To the 
extent the terms of the exchange do not specify the other property or 
money that is received in exchange for a particular share of stock or 
security surrendered, a pro rata portion of the other property and 
money received is treated as received in exchange for each share of 
stock and security surrendered, based on the fair market value of such 
surrendered share of stock or security.
    The IRS and Treasury Department are aware that there is a question 
as to the proper treatment of the basis of stock exchanged for boot in 
the following circumstances. This question arises, in part, as a result 
of the operation of section 356. Section 356 generally applies if 
section 354 would apply to an exchange but for the fact that the 
property received in the exchange consists not only of property 
permitted by section 354 to be received without the recognition of gain 
but also of other property or money. Section 356(c) provides that no 
loss realized from such an exchange may be recognized.
    Suppose A holds 100 shares of Corporation T common stock and 100 
shares of Corporation T preferred stock. The common shares have an 
aggregate basis of $10 and an aggregate fair market value of $100 and 
the preferred shares have an aggregate basis of $150 and an aggregate 
fair market value of $100. Corporation T merges with and into 
Corporation X in a reorganization under section 368. The terms of the 
exchange specify that A exchanges its shares of Corporation T common 
stock for 100 shares of Corporation X common stock with an aggregate 
fair market value of $100 and exchanges its shares of Corporation T 
preferred stock for $100 of cash. Under these final regulations, the 
terms of the exchange control for purposes of determining gain under 
section 356 and basis under section 358. Under section 356(c), A 
realizes a gain of $90 on the exchange of Corporation T common stock 
for Corporation X common stock, none of which is

[[Page 4266]]

recognized under section 356 and A takes an aggregate basis of $10 in 
the shares of Corporation X common stock received in the exchange. 
However, A realizes a loss of $50 on the exchange of Corporation T 
preferred stock for cash. Therefore, A would not be entitled to 
recognize any of the loss realized. This conclusion is consistent with 
Revenue Ruling 74-515. In that ruling, a shareholder surrenders common 
stock of the target corporation in exchange for common stock of the 
acquiring corporation and preferred stock of the target corporation in 
exchange for cash. The ruling concludes that the tax consequences of 
the shareholder's exchange of preferred shares for cash are governed by 
section 356 and any loss realized is not recognized by reason of 
section 356(c).
    The IRS and Treasury Department are considering, and request 
comments regarding, whether regulations should be adopted interpreting 
section 356 in a manner that would permit a taxpayer, such as A, in the 
circumstances described above to recognize the loss in these types of 
fact patterns. If an approach permitting recognition of loss in these 
cases is not adopted, then an issue arises as to the proper treatment 
of the basis of the shares with respect to which the loss is realized 
but not recognized, at least to the extent that such basis exceeds the 
cash received in respect of such shares. The IRS and Treasury 
Department request comments on the proper treatment of such basis.

C. Retained Shares of Stock or Securities in Section 355 Exchanges

    As described above, the proposed regulations provide that the basis 
of each share of stock or security received in an exchange to which 
section 355 applies is generally the same as the basis of the share or 
shares of stock or security or securities exchanged therefor. This rule 
applies even if the exchanging shareholder or security holder retains 
shares of stock or securities in the distributing corporation. If the 
shareholder or security shareholder retains shares of stock or 
securities in the distributing corporation, the basis of those 
instruments remains unaffected. One commentator suggested that this 
approach might be viewed as inconsistent with the statutory language of 
section 358(b)(2).
    Section 358(b)(2) generally provides that in allocating basis among 
the property permitted to be received without the recognition of gain 
or loss in an exchange to which section 355 applies, there shall be 
taken into account not only the property so permitted to be received 
without the recognition of gain or loss, but also the stock or 
securities (if any) of the distributing corporation that are retained 
and the allocation of basis must be made among all such properties. 
Neither the statutory language of section 358(b)(2) nor its legislative 
history indicates the method of allocation that Congress contemplated 
when it enacted this provision.
    The IRS and Treasury Department believe that the rule of the 
proposed regulations is a reasonable approach to the implementation of 
section 358(b)(2). Nonetheless, the IRS and Treasury Department did 
consider alternative approaches.
    For example, the IRS and Treasury Department considered adopting an 
approach that would aggregate the basis of the shares of stock and 
securities of the distributing corporation owned by a particular 
shareholder and then would allocate such basis among the shares of 
stock and securities in the distributing and controlled corporations 
owned by that shareholder immediately after the distribution based on 
their fair market values. Such an approach would effectively be an 
averaging approach for certain types of exchanges, an approach that is 
inconsistent with the view that a reorganization is not an event that 
justifies averaging the bases of exchanged stock that had been 
purchased at different times and at different prices and that would 
result in the inconsistent treatment of exchanges under section 354, 
355, and 356.
    The IRS and Treasury Department also considered adopting an 
approach that would have treated the shareholder or security holder as 
receiving a distribution of stock or securities on each share of stock 
or security that it owned in the distributing corporation, followed by 
a recapitalization of both the distributing and controlled corporations 
to reflect the shareholders' and security holders' actual stock and 
security ownership immediately after the transaction. The IRS and 
Treasury Department, however, were concerned that this approach would 
be complex and inadministrable, especially in cases in which a 
shareholder holds stock of the distributing corporation in multiple 
accounts.
    For the reasons described above, these two alternative approaches 
were rejected. Therefore, these final regulations do not alter the 
operation of the rules of the proposed regulations in this context.

D. Stockless Reorganizations

    A number of commentators observed that it is not clear how basis 
should be determined in the case of a reorganization in which no stock 
is issued. Such a situation may arise in reorganizations involving 
commonly controlled acquiring and target corporations where the 
issuance of additional stock of the acquiring corporation would 
constitute a meaningless gesture. One commentator suggested an approach 
that would treat the acquiring corporation as issuing an amount of 
stock equal to the fair market value of the stock surrendered. The 
basis of that deemed issued stock would have a basis traced from the 
shares surrendered in the reorganization under the rules that would 
have applied had the shareholder actually received such stock. Then, 
the shareholder's stock in the acquiring corporation would be treated 
as recapitalized. In the recapitalization, the shareholder would be 
treated as surrendering all of its shares of the acquiring corporation, 
including those shares owned immediately prior to the reorganization 
and those shares the shareholder is deemed to receive, in exchange for 
the shares that the shareholder actually holds immediately after the 
reorganization. The basis of the shares that the shareholder actually 
owns would be determined under the rules that would have applied had 
the recapitalization actually occurred with respect to the 
shareholder's actual shares and the shares the shareholder is deemed to 
have received.
    For example, suppose P wholly owns S1 and S2. P owns 100 shares of 
S1, each of which has a basis of $1 and was acquired on Date 1, and 100 
shares of S2, each of which has a basis of $2 and was acquired on Date 
2. The fair market value of each share of the stock of each of S1 and 
S2 is $1. S1 merges into S2 in a reorganization under section 
368(a)(1)(D) in which P does not receive any additional stock of S2. 
Under the suggested approach, P would be treated as receiving 100 
shares of S2, each of which has a fair market value of $1. The basis of 
those additional 100 shares would be determined as if P had actually 
received those shares. Therefore, each of those shares would have a 
basis of $1. Then, to reflect that P has only 100 shares of S2 stock 
rather than 200 shares, S2 would be treated as undergoing a reverse 
stock split in which it exchanges two shares of its stock for one 
share. The basis of each of the 100 shares would be determined as if 
the reverse stock split had actually occurred. Therefore, 50 shares of 
P's S2 stock would each have a basis of $2 and would be treated as 
having been acquired on Date 1 and the remaining 50

[[Page 4267]]

shares of P's S2 stock would each have a basis of $4 and would be 
treated as having been acquired on Date 2.
    The IRS and Treasury Department believe that the approach suggested 
is consistent with the general tracing approach of the proposed 
regulations. Accordingly, these final regulations adopt the suggested 
approach for cases in which a shareholder of the target corporation 
receives no property or property with a fair market value less than 
that of the stock or securities the shareholder surrendered in the 
transaction.

E. Single Versus Split Basis Approaches

    The proposed regulations provide that if one share of stock or 
security is received in exchange for, or with respect to, more than one 
share of stock or security or a fraction of a share of stock or 
security is received, the basis of the shares of surrendered stock or 
securities must be allocated to the shares of stock or securities 
received in a manner that reflects, to the greatest extent possible, 
that a share of stock or security received is received in exchange for, 
or with respect to, shares of stock or securities that were acquired on 
the same date and at the same price. The preamble states that this rule 
avoids, to the greatest extent possible, creating shares of stock or 
securities with split holding periods. Several commentators have 
requested guidance regarding whether a share that reflects the basis of 
several shares with differing bases has a single, aggregated basis or a 
split basis. For example, suppose B has two shares of stock of T. One 
of those shares has a basis of $1 and was acquired on Date 1. The other 
share has a basis of $2 and was acquired on Date 2. A, a corporation, 
acquires the assets of T in a reorganization under section 
368(a)(1)(A). In the reorganization, B exchanges its two shares of T 
stock for one share of A stock. One possibility is that B has a single, 
undivided $3 basis in its share of A stock. Another possibility is that 
B has a split basis in its share of A stock such that half of the share 
is treated as having a basis of $1 and the other half is treated as 
having a basis of $2.
    The IRS and Treasury Department believe that because the single, 
aggregated basis approach has the effect of averaging the basis of more 
than one share, it is inconsistent with the tracing regime adopted in 
these final regulations. Moreover, as suggested in the preamble of the 
proposed regulations, the IRS and Treasury Department believe that it 
is possible for a share to have a split holding period. The IRS and 
Treasury Department believe that the split basis approach is a logical 
corollary to the split holding period approach. Therefore, these final 
regulations reflect that a share may have not only a split holding 
period, but also a split basis.

F. Coordination with Section 1036

    Section 1036 provides that no gain or loss is recognized if common 
stock is exchanged for common stock, or preferred stock is exchanged 
for preferred stock, in the same corporation. Section 1031 provides 
rules for determining the basis of the common or preferred stock 
received in an exchange described in section 1036. One commentator 
requested clarification regarding whether the basis tracing rules of 
the proposed regulations apply to transactions governed by both section 
1036 and section 354 or 356.
    The IRS and Treasury Department believe that those same policies 
that support the application of a tracing regime in the context of 
transactions governed solely by section 354 or 356 support the 
application of a tracing regime in the context of transactions governed 
by both section 1036, on the one hand, and section 354 or 356, on the 
other hand. Accordingly, these final regulations provide that the 
tracing rules apply to determine the basis of a share of stock or 
security received by a shareholder or security holder in an exchange 
described in both section 1036, on the one hand, and section 354 or 
section 356, on the other hand. The IRS and Treasury Department 
continue to study whether the rules of these final regulations should 
be adopted in regulations under section 1036 for transactions governed 
by section 1036, but not section 354 or 356.

G. Application of Tracing Rules to Section 351 Transactions

    Under the proposed regulations, the tracing rules do not apply to 
an exchange described in section 351, unless such exchange is also 
described in section 354 or section 356 and certain other requirements 
are satisfied. One commentator urged the IRS and Treasury Department to 
consider expanding the tracing regime of the proposed regulations to 
apply more broadly to exchanges governed by section 351. That 
commentator suggested that having different regimes apply to the 
determination of the basis of stock received in a tax-free exchange for 
stock is undesirable.
    The IRS and Treasury Department are continuing to study the 
possible application of a tracing approach more broadly to exchanges 
described in section 351. In the meantime, these final regulations 
retain those limitations on the application of the basis tracing regime 
to exchanges described in section 351 that were included in the 
proposed regulations.

H. Excess Loss Accounts

    Section 1.1502-19(d) provides that if a member (P) of a 
consolidated group has an excess loss account in shares of a class of 
another member's (S's) stock at the time of a basis adjustment or 
determination under the Internal Revenue Code with respect to other 
shares of the same class of S's stock owned by the member, the 
adjustment or determination is allocated first to equalize and 
eliminate that member's excess loss account. The rule reflects a policy 
of permitting the elimination of excess loss accounts. The application 
of the rule, however, is sensitive to the form of the transaction. For 
example, if P owns all of the stock of S with an excess loss account of 
$100 and all of the stock of T with a basis of $150, and T merges into 
S in a reorganization under section 368(a)(1)(D) in which P receives 
additional shares of S stock, under Sec.  1.1502-19(d), P's excess loss 
account in its original shares of S stock is first eliminated. 
Therefore, P's original S shares will have an aggregate basis of $0 and 
P's new S shares will have an aggregate basis of $50. If, instead, 
however, S merges into T in a reorganization under section 368(a)(1)(D) 
in which P receives additional shares of T stock, because P does not 
already have T shares that have an excess loss account, Sec.  1.1502-
19(d) does not apply. Therefore, P's original T shares will have a 
basis of $150 and P's new T shares will have an excess loss account of 
$100.
    The limitation on the application of Sec.  1.1502-19(d) to cases in 
which a basis adjustment or determination is made with respect to 
shares of a class of stock of the corporation in which the member holds 
other shares with an excess loss account effectively makes the rule 
elective. That is, if the transaction occurs in one direction (in the 
example above, T merges into S), the rule applies. If the transaction 
occurs in the other direction (in the example above, S merges into T), 
the rule does not apply. The IRS and Treasury Department believe that 
this electivity is undesirable. Therefore, the IRS and Treasury 
Department believe that it is appropriate to expand the scope of the 
application of the rule of Sec.  1.1502-19(d). Accordingly, the 
temporary regulations included in this Treasury decision add an 
additional rule to Sec.  1.1502-19 that provides that if a member would 
otherwise determine shares of a class of S's stock (a new share) to 
have an excess

[[Page 4268]]

loss account and such member owns one or more other shares of the same 
class of S's stock, the basis of such other shares is allocated to 
eliminate and equalize any excess loss account that would otherwise be 
in the new shares. Therefore, in the example above where S merges into 
T in a reorganization under section 368(a)(1)(D) in which P receives 
additional shares of T stock, the basis of P's original T shares will 
first be applied to eliminate the excess loss account that P would 
otherwise have in its new T shares. Therefore, P will have an aggregate 
basis of $50 in its original T shares and an aggregate basis of $0 in 
its new T shares.

Effective Date

    The final and temporary regulations apply to exchanges and 
distributions of stock or securities and determinations of stock basis 
occurring on or after the date these regulations are filed as final 
regulations in the Federal Register.

Effect on Other Documents

    The following publication is obsolete as of January 23, 2006:
    Revenue Ruling 55-355 (1955-1 C.B. 418).

Special Analyses

    It has been determined that the final regulations issued with 
respect to section 358 and section 1502 are not a significant 
regulatory action as defined in Executive Order 12866. Therefore, a 
regulatory assessment is not required. It has also been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C chapter 5) 
does not apply to these regulations, and, because the regulations do 
not impose a collection of information on small entities, the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.
    It has been determined that the temporary regulations issued with 
respect to section 1502 are not a significant regulatory action as 
defined in Executive Order 12866. Therefore, a regulatory assessment is 
not required. These temporary regulations are necessary to provide 
taxpayers with immediate guidance regarding the application of section 
358 when a member of a consolidated group has an excess loss account in 
the stock of another member and consequences of such application. 
Accordingly, good cause is found for dispensing with notice and public 
procedure pursuant to 5 U.S.C. 553(b)(B) and with a delayed effective 
date pursuant to 5 U.S.C. 553(d)(3). For applicability of the 
Regulatory Flexibility Act, please refer to the cross-reference notice 
of proposed rulemaking published elsewhere in the Federal Register. 
Pursuant to section 7805(f) of the Code, these temporary regulations 
will be submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on their impact on small business.

Drafting Information

    The principal authors of these regulations are Emidio J. Forlini, 
Jr. and Theresa M. Kolish of the Office of the Associate Chief Counsel 
(Corporate), IRS. However, other personnel from the IRS and the 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.358-2 also issued under 26 U.S.C. 358. * * *
    Section 1.1502-19T also issued under 26 U.S.C. 1502. * * *
    Section 1.1502-32 also issued under 26 U.S.C. 1502. * * *


0
Par. 2. Section 1.356-1 is revised to read as follows:


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

    (a) If in any exchange to which the provisions of section 354 or 
section 355 would apply except for the fact that there is received by 
the shareholders or security holders other property (in addition to 
property permitted to be received without recognition of gain by such 
sections) or money, then--
    (1) The gain, if any, to the taxpayer shall be recognized in an 
amount not in excess of the sum of the money and the fair market value 
of the other property, but,
    (2) The loss, if any, to the taxpayer from the exchange or 
distribution shall not be recognized to any extent.
    (b) For purposes of computing the gain, if any, recognized pursuant 
to section 356 and paragraph (a)(1) of this section, to the extent the 
terms of the exchange specify the other property or money that is 
received in exchange for a particular share of stock or security 
surrendered or a particular class of stock or securities surrendered, 
such terms shall control provided that such terms are economically 
reasonable. To the extent the terms of the exchange do not specify the 
other property or money that is received in exchange for a particular 
share of stock or security surrendered or a particular class of stock 
or securities surrendered, a pro rata portion of the other property and 
money received shall be treated as received in exchange for each share 
of stock and security surrendered, based on the fair market value of 
such surrendered share of stock or security.
    (c) If the distribution of such other property or money by or on 
behalf of a corporation has the effect of the distribution of a 
dividend, then there shall be chargeable to each distributee (either an 
individual or a corporation)--
    (1) As a dividend, such an amount of the gain recognized as is not 
in excess of the distributee's ratable share of the undistributed 
earnings and profits of the corporation accumulated after February 28, 
1913, and
    (2) As a gain from the exchange of property, the remainder of the 
gain so recognized.
    (d) The rules of this section may be illustrated by the following 
examples:

    Example 1. In an exchange to which the provisions of section 356 
apply and to which section 354 would apply but for the receipt of 
property not permitted to be received without the recognition of 
gain or loss, A (either an individual or a corporation), received 
the following in exchange for a share of stock having an adjusted 
basis to A of $85:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
One share of stock worth...................................         $100
Cash.......................................................           25
Other property (basis $25) fair market value...............           50
                                                            ============
    Adjusted basis of stock surrendered in exchange........           85

[[Page 4269]]

 
        Total gain.........................................           90
                                                            ============
A's pro rata share of earnings and profits accumulated                30
 after February 28, 1913 (taxable dividend)................
 
------------------------------------------------------------------------

    Example 2. If, in Example 1, A's stock had an adjusted basis to 
A of $200, A would have realized a loss of $25 on the exchange, 
which loss would not be recognized.
    Example 3. (i) Facts. J, an individual, acquired 10 shares of 
Class A stock of Corporation X on Date 1 for $3 each and 10 shares 
of Class B stock of Corporation X on Date 2 for $9 each. On Date 3, 
Corporation Y acquires the assets of Corporation X in a 
reorganization under section 368(a)(1)(A). Pursuant to the terms of 
the plan of reorganization, J surrenders all of J's shares of 
Corporation X stock for 10 shares of Corporation Y stock and $100 of 
cash. On the date of the exchange, the fair market value of each 
share of Class A stock of Corporation X is $10, the fair market 
value of each share of Class B stock of Corporation X is $10, and 
the fair market value of each share of Corporation Y stock is $10. 
The terms of the exchange do not specify that shares of Corporation 
Y stock or cash are received in exchange for particular shares of 
Class A stock or Class B stock of Corporation X.
    (ii) Analysis. Under paragraph (b) of this section, because the 
terms of the exchange do not specify that the cash is received in 
exchange for shares of Class A or Class B stock of Corporation X, a 
pro rata portion of the cash received is treated as received in 
exchange for each share of Class A stock of Corporation X and each 
share of Class B stock of Corporation X based on the fair market 
value of the surrendered shares. Therefore, J is treated as 
receiving shares of Corporation Y stock with a fair market value of 
$50 and $50 of cash in exchange for its shares of Class A stock of 
Corporation X and shares of Corporation Y stock with a fair market 
value of $50 and $50 of cash in exchange for its shares of Class B 
stock of Corporation X. J realizes a gain of $70 on the exchange of 
shares of Class A stock, $50 of which is recognized under section 
356 and paragraph (a) of this section, and J realizes a gain of $10 
on the exchange of shares of Class B stock of Corporation X, all of 
which is recognized under section 356 and paragraph (a) of this 
section. Assuming that J's gain recognized is not treated as a 
dividend under section 356(a)(2), such gain shall be treated as gain 
from the exchange of property.
    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that the terms of the plan of reorganization specify that J 
receives 10 shares of stock of Corporation Y in exchange for J's 
shares of Class A stock of Corporation X and $100 of cash in 
exchange for J's shares of Class B stock of Corporation X.
    (ii) Analysis. Under paragraph (b) of this section, because the 
terms of the exchange specify that J receives 10 shares of stock of 
Corporation Y in exchange for J's shares of Class A stock of 
Corporation X and $100 of cash in exchange for J's shares of Class B 
stock of Corporation X and such terms are economically reasonable, 
such terms control. J realizes a gain of $70 on the exchange of 
shares of Class A stock, none of which is recognized under section 
356 and paragraph (a) of this section, and J realizes a gain of $10 
on the exchange of shares of Class B stock of Corporation X, all of 
which is recognized under section 356 and paragraph (a) of this 
section.

    (e) Section 301(b)(1)(B) and section 301(d)(2) do not apply to a 
distribution of ``other property'' to a corporate shareholder if such 
distribution is within the provisions of section 356.
    (f) See paragraph (l) of Sec. 1.301-1 for certain transactions 
which are not within the scope of section 356.
    (g) This section applies to exchanges and distributions of stock 
and securities occurring on or after January 23, 2006.

0
Par. 3. Section 1.358-1 is revised to read as follows:


Sec.  1.358-1  Basis to distributees.

    (a) In the case of an exchange to which section 354 or 355 applies 
in which, under the law applicable to the year in which the exchange is 
made, only nonrecognition property is received, immediately after the 
transaction, the sum of the basis of all of the stock and securities 
received in the transaction shall be the same as the basis of all the 
stock and securities in such corporation surrendered in the 
transaction, allocated in the manner described in Sec. 1.358-2. In the 
case of a distribution to which section 355 applies in which, under the 
law applicable to the year in which the distribution is made, only 
nonrecognition property is received, immediately after the transaction, 
the sum of the basis of all of the stock and securities with respect to 
which the distribution is made plus the basis of all stock and 
securities received in the distribution with respect to such stock and 
securities shall be the same as the basis of the stock and securities 
with respect to which the distribution is made immediately before the 
transaction, allocated in the manner described in Sec. 1.358-2. In the 
case of an exchange to which section 351 or 361 applies in which, under 
the law applicable to the year in which the exchange was made, only 
nonrecognition property is received, the basis of all the stock and 
securities received in the exchange shall be the same as the basis of 
all property exchanged therefor. If in an exchange or distribution to 
which section 351, 356, or 361 applies both nonrecognition property and 
``other property'' are received, the basis of all the property except 
``other property'' held after the transaction shall be determined as 
described in the preceding three sentences decreased by the sum of the 
money and the fair market value of the ``other property'' (as of the 
date of the transaction) and increased by the sum of the amount treated 
as a dividend (if any) and the amount of the gain recognized on the 
exchange, but the term gain as here used does not include any portion 
of the recognized gain that was treated as a dividend. In any case in 
which a taxpayer transfers property with respect to which loss is 
recognized, such loss shall be reflected in determining the basis of 
the property received in the exchange. The basis of the ``other 
property'' is its fair market value as of the date of the transaction. 
See Sec. 1.460-4(k)(3)(iv)(A) for rules relating to stock basis 
adjustments required where a contract accounted for using a long-term 
contract method of accounting is transferred in a transaction described 
in section 351 or a reorganization described in section 368(a)(1)(D) 
with respect to which the requirements of section 355 (or so much of 
section 356 as relates to section 355) are met.
    (b) The application of paragraph (a) of this section may be 
illustrated by the following example:

    Example. A purchased a share of stock in Corporation X in 1935 
for $150. Since that date A has received distributions out of other 
than earnings and profits (as defined in section 316) totaling $60, 
so that A's adjusted basis for the stock is $90. In a transaction 
qualifying under section 356, A exchanged this share for one share 
in Corporation Y, worth $100, cash in the amount of $10, and other 
property with a fair market value of $30. The exchange had the 
effect of the distribution of a dividend. A's ratable share of the 
earnings and profits of Corporation X accumulated after February 28, 
1913, was $5. A realized a gain of $50 on the exchange, but the 
amount recognized is limited to $40, the sum of the cash received 
and the fair market value of the other property. Of the gain 
recognized, $5 is taxable as a dividend, and $35 is taxable as a 
gain from the exchange of property. The basis to A of the one share 
of stock of Corporation Y is $90. That is, the adjusted basis of the 
one share of stock Corporation X ($90), decreased by the sum of the 
cash received ($10) and the fair market

[[Page 4270]]

value of the other property received ($30) and increased by the sum 
of the amount treated as a dividend ($5) and the amount treated as a 
gain from the exchange of property ($35). The basis of the other 
property received is $30.

    (c) This section applies to exchanges and distributions of stock 
and securities occurring on or after January 23, 2006.

0
Par. 4. Section 1.358-2 is amended by:
0
1. Revising paragraphs (a)(1) and (a)(2).
0
2. Removing paragraphs (a)(3), (a)(4), and (a)(5).
0
3. Revising paragraphs (b)(1) and (c).
0
4. Adding paragraph (d).
    The revisions and addition read as follows:


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

    (a) Allocation of basis in exchanges or distributions to which 
section 354, 355, or 356 applies. (1) As used in this paragraph the 
term stock means stock which is not ``other property'' under section 
356. The term securities means securities (including, where 
appropriate, fractional parts of securities) which are not ``other 
property'' under section 356. Stock, or securities, as the case may be, 
which differ either because they are in different corporations or 
because the rights attributable to them differ (although they are in 
the same corporation) are considered different classes of stock or 
securities, as the case may be, for purposes of this section.
    (2)(i) If a shareholder or security holder surrenders a share of 
stock or a security in an exchange under the terms of section 354, 355, 
or 356, the basis of each share of stock or security received in the 
exchange shall be the same as the basis of the share or shares of stock 
or security or securities (or allocable portions thereof) exchanged 
therefor (as adjusted under Sec.  1.358-1). If more than one share of 
stock or security is received in exchange for one share of stock or one 
security, the basis of the share of stock or security surrendered shall 
be allocated to the shares of stock or securities received in the 
exchange in proportion to the fair market value of the shares of stock 
or securities received. If one share of stock or security is received 
in exchange for more than one share of stock or security or if a 
fraction of a share of stock or security is received, then the basis of 
the shares of stock or securities surrendered must be allocated to the 
shares of stock or securities (or allocable portions thereof) received 
in a manner that reflects, to the greatest extent possible, that a 
share of stock or security received is received in respect of shares of 
stock or securities that were acquired on the same date and at the same 
price. To the extent it is not possible to allocate basis in this 
manner, the basis of the shares of stock or securities surrendered must 
be allocated to the shares of stock or securities (or allocable 
portions thereof) received in a manner that minimizes the disparity in 
the holding periods of the surrendered shares of stock or securities 
whose basis is allocated to any particular share of stock or security 
received.
    (ii) If a shareholder or security holder surrenders a share of 
stock or a security in an exchange under the terms of section 354, 355, 
or 356, and receives shares of stock or securities of more than one 
class, or receives ``other property'' or money in addition to shares of 
stock or securities, then, to the extent the terms of the exchange 
specify that shares of stock or securities of a particular class or 
``other property'' or money is received in exchange for a particular 
share of stock or security or a particular class of stock or 
securities, for purposes of applying the rules of this section, such 
terms shall control provided such terms are economically reasonable. To 
the extent the terms of the exchange do not specify that shares of 
stock or securities of a particular class or ``other property'' or 
money is received in exchange for a particular share of stock or 
security or a particular class of stock or securities, then, for 
purposes of applying the rules of paragraph (a)(2)(i) of this section, 
a pro rata portion of the shares of stock and securities of each class 
received and a pro rata portion of the ``other property'' and money 
received shall be treated as received in exchange for each share of 
stock and security surrendered, based on the fair market value of the 
stock and securities surrendered.
    (iii) For purposes of this section, if a shareholder or security 
holder surrenders a share of stock or a security in a transaction under 
the terms of section 354 (or so much of section 356 as relates to 
section 354) in which such shareholder or security holder receives no 
property or property (including property permitted by section 354 to be 
received without the recognition of gain or ``other property'' or 
money) with a fair market value less than that of the stock or 
securities surrendered in the transaction, such shareholder or security 
holder shall be treated as follows. First, the shareholder or security 
holder shall be treated as receiving the stock, securities, other 
property, and money actually received by the shareholder or security 
holder in the transaction and an amount of stock of the issuing 
corporation (as defined in Sec. 1.368-1(b)) that has a value equal to 
the excess of the value of the stock or securities the shareholder or 
security holder surrendered in the transaction over the value of the 
stock, securities, other property, and money the shareholder or 
security holder actually received in the transaction. If the 
shareholder owns only one class of stock of the issuing corporation the 
receipt of which would be consistent with the economic rights 
associated with each class of stock of the issuing corporation, the 
stock deemed received by the shareholder pursuant to the previous 
sentence shall be stock of such class. If the shareholder owns multiple 
classes of stock of the issuing corporation the receipt of which would 
be consistent with the economic rights associated with each class of 
stock of the issuing corporation, the stock deemed received by the 
shareholder shall be stock of each such class owned by the shareholder 
immediately prior to the transaction, in proportion to the value of the 
stock of each such class owned by the shareholder immediately prior to 
the transaction. The basis of each share of stock or security deemed 
received and actually received shall be determined under the rules of 
this section. Second, the shareholder or security holder shall then be 
treated as surrendering all of its shares of stock and securities in 
the issuing corporation, including those shares of stock or securities 
held immediately prior to the transaction, those shares of stock or 
securities actually received in the transaction, and those shares of 
stock deemed received pursuant to the previous sentence, in a 
reorganization under section 368(a)(1)(E) in exchange for the shares of 
stock and securities of the issuing corporation that the shareholder or 
security holder actually holds immediately after the transaction. The 
basis of each share of stock and security deemed received in the 
reorganization under section 368(a)(1)(E) shall be determined under the 
rules of this section.
    (iv) If a shareholder or security holder receives one or more 
shares of stock or one or more securities in a distribution under the 
terms of section 355 (or so much of section 356 as relates to section 
355), the basis of each share of stock or security of the distributing 
corporation (as defined in Sec. 1.355-1(b)), as adjusted under 
Sec. 1.358-1, shall be allocated between the share of stock or security 
of the distributing corporation with respect to which the distribution 
is made and the share or shares of stock or security or securities (or 
allocable portions

[[Page 4271]]

thereof) received with respect to the share of stock or security of the 
distributing corporation in proportion to their fair market values. If 
one share of stock or security is received with respect to more than 
one share of stock or security or if a fraction of a share of stock or 
security is received, then the basis of each share of stock or security 
of the distributing corporation must be allocated to the shares of 
stock or securities (or allocable portions thereof) received in a 
manner that reflects that, to the greatest extent possible, a share of 
stock or security received is received with respect to shares of stock 
or securities acquired on the same date and at the same price. To the 
extent it is not possible to allocate basis in this manner, the basis 
of each share of stock or security of the distributing corporation must 
be allocated to the shares of stock or securities (or allocable 
portions thereof) received in a manner that minimizes the disparity in 
the holding periods of the shares of stock or securities with respect 
to which such shares of stock or securities are received.
    (v) If a shareholder or security holder receives shares of stock or 
securities of more than one class, or receives ``other property'' or 
money in addition to stock or securities in a distribution under the 
terms of section 355 (or so much of section 356 as relates to section 
355), then, to the extent the terms of the distribution specify that 
shares of stock or securities of a particular class or ``other 
property'' or money is received with respect to a particular share of 
stock or security of the distributing corporation or a particular class 
of stock or securities of the distributing corporation, for purposes of 
applying the rules of this section, such terms shall control provided 
that such terms are economically reasonable. To the extent the terms of 
the distribution do not specify that shares of stock or securities of a 
particular class or ``other property'' or money is received with 
respect to a particular share of stock or security of the distributing 
corporation or a particular class of stock or securities of the 
distributing corporation, then, for purposes of applying the rules of 
this section, a pro rata portion of the shares of stock and securities 
of each class received and a pro rata portion of the ``other property'' 
and money received shall be treated as received with respect to each 
share of stock and security of the distributing corporation with 
respect to which the distribution is made, based on the fair market 
value of each such share of stock or security.
    (vi) If a share of stock or a security is received in exchange for, 
or with respect to, more than one share of stock or security and such 
shares or securities were acquired on different dates or at different 
prices, the share of stock or security received shall be divided into 
segments based on the relative fair market values of the shares of 
stock or securities surrendered in exchange for such share or security 
or the relative fair market values of the shares of stock or securities 
with respect to which the share of stock or security is received in a 
distribution under the terms of section 355 (or so much of section 356 
as relates to section 355)). Each segment shall have a basis determined 
under the rules of paragraph (a)(2) of this section and a corresponding 
holding period.
    (vii) If a shareholder or security holder that purchased or 
acquired shares of stock or securities in a corporation on different 
dates or at different prices exchanges such shares of stock or 
securities under the terms of section 354, 355, or 356, or receives a 
distribution of shares of stock or securities under the terms of 
section 355 (or so much of section 356 as relates to section 355), and 
the shareholder or security holder is not able to identify which 
particular share of stock or security (or allocable portion of a share 
of stock or security) is received (or deemed received) in exchange for, 
or with respect to, a particular share of stock or security, the 
shareholder or security holder may designate which share of stock or 
security is received in exchange for, or with respect to, a particular 
share of stock or security, provided that such designation is 
consistent with the terms of the exchange or distribution (or an 
exchange deemed to have occurred pursuant to paragraph (a)(2)(iii) of 
this section), and the other rules of this section. In the case of an 
exchange under the terms of section 354 or 356 (including a deemed 
exchange as a result of the application of paragraph (a)(2)(iii) of 
this section), the designation must be made on or before the first date 
on which the basis of a share of stock or a security received (or 
deemed received in the reorganization under section 368(a)(1)(E) in the 
case of a transaction to which paragraph (a)(2)(iii) of this section 
applies) is relevant. In the case of an exchange or distribution under 
the terms of section 355 (or so much of section 356 as relates to 
section 355), the designation must be made on or before the first date 
on which the basis of a share of stock or a security of the 
distributing corporation or the controlled corporation (as defined in 
Sec.  1.355-1(b)) is relevant. The basis of the shares or securities 
received in an exchange under the terms of section 354 or section 356, 
for example, is relevant when such shares or securities are sold or 
otherwise transferred. The designation will be binding for purposes of 
determining the Federal tax consequences of any sale or transfer of, or 
distribution with respect to, the shares or securities received. If the 
shareholder fails to make a designation in a case in which the 
shareholder is not able to identify which share of stock is received in 
exchange for, or with respect to, a particular share of stock, then the 
shareholder will not be able to identify which shares are sold or 
transferred for purposes of determining the basis of property sold or 
transferred under section 1012 and Sec. 1.1012-1(c) and, instead, will 
be treated as selling or transferring the share received in respect of 
the earliest share purchased or acquired.
    (viii) This paragraph (a)(2) shall not apply to determine the basis 
of a share of stock or security received by a shareholder or security 
holder in an exchange described in both section 351 and section 354 or 
section 356, if, in connection with the exchange, the shareholder or 
security holder exchanges property for stock or securities in an 
exchange to which neither section 354 nor 356 applies or liabilities of 
the shareholder or security holder are assumed.
    (ix) This paragraph (a)(2) shall apply to determine the basis of a 
share of stock or security received by a shareholder or security holder 
in an exchange described in both section 1036 and section 354 or 
section 356.
    (b) Allocation of basis in exchanges to which section 351 or 361 
applies. (1) As used in this paragraph (b), the term stock refers only 
to stock which is not ``other property'' under section 351 or 361 and 
the term securities refers only to securities which are not ``other 
property'' under section 351 or 361.
* * * * *
    (c) Examples. The application of paragraphs (a) and (b) of this 
section is illustrated by the following examples:

    Example 1. (i) Facts. J, an individual, acquired 20 shares of 
Corporation X stock on Date 1 for $3 each and 10 shares of 
Corporation X stock on Date 2 for $6 each. On Date 3, Corporation Y 
acquires the assets of Corporation X in a reorganization under 
section 368(a)(1)(A). Pursuant to the terms of the plan of 
reorganization, J receives 2 shares of Corporation Y stock in 
exchange for each share of Corporation X stock. Therefore, J 
receives 60 shares of Corporation Y stock. Pursuant to section 354, 
J recognizes no gain or loss on the exchange. J is not able to

[[Page 4272]]

identify which shares of Corporation Y stock are received in 
exchange for each share of Corporation X stock.
    (ii) Analysis. Under paragraph (a)(2)(i) of this section, J has 
40 shares of Corporation Y stock each of which has a basis of $1.50 
and is treated as having been acquired on Date 1 and 20 shares of 
Corporation Y stock each of which has a basis of $3 and is treated 
as having been acquired on Date 2. Under paragraph (a)(2)(vii) of 
this section, on or before the date on which the basis of a share of 
Corporation Y stock received becomes relevant, J may designate which 
of the shares of Corporation Y stock have a basis of $1.50 and which 
have a basis of $3.
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that instead of receiving 2 shares of Corporation Y stock in 
exchange for each share of Corporation X stock, J receives 1\1/2\ 
shares of Corporation Y stock in exchange for each share of 
Corporation X stock. Therefore, J receives 45 shares of Corporation 
Y stock. Again, J is not able to identify which shares (or portions 
of shares) of Corporation Y stock are received in exchange for each 
share of Corporation X stock.
    (ii) Analysis. Under paragraph (a)(2)(i) of this section, J has 
30 shares of Corporation Y stock each of which has a basis of $2 and 
is treated as having been acquired on Date 1 and 15 shares of 
Corporation Y stock each of which has a basis of $4 and is treated 
as having been acquired on Date 2. Under paragraph (a)(2)(vii) of 
this section, on or before the date on which the basis of a share of 
Corporation Y stock received becomes relevant, J may designate which 
of the shares of Corporation Y stock received have a basis of $2 and 
which have a basis of $4.
    Example 3. (i) Facts. J, an individual, acquired 10 shares of 
Class A stock of Corporation X on Date 1 for $3 each, 10 shares of 
Class A stock of Corporation X on Date 2 for $9 each, and 10 shares 
of Class B stock of Corporation X on Date 3 for $3 each. On Date 4, 
J surrenders all of J's shares of Class A stock in exchange for 20 
shares of new Class C stock and 20 shares of new Class D stock in a 
reorganization under section 368(a)(1)(E). Pursuant to section 354, 
J recognizes no gain or loss on the exchange. On the date of the 
exchange, the fair market value of each share of Class A stock is 
$6, the fair market value of each share of Class C stock is $2, and 
the fair market value of each share of Class D stock is $4. The 
terms of the exchange do not specify that shares of Class C stock or 
shares of Class D stock of Corporation X are received in exchange 
for particular shares of Class A stock of Corporation X.
    (ii) Analysis. Under paragraph (a)(2)(ii) of this section, 
because the terms of the exchange do not specify that shares of 
Class C stock or shares of Class D stock of Corporation X are 
received in exchange for particular shares of Class A stock of 
Corporation X, a pro rata portion of the shares of Class C stock and 
shares of Class D stock received will be treated as received in 
exchange for each share of Class A stock based on the fair market 
value of the surrendered shares of Class A stock. Therefore, J is 
treated as receiving one share of Class C stock and one share of 
Class D stock in exchange for each share of Class A stock. Under 
paragraph (a)(2)(i) of this section, J has 10 shares of Class C 
stock, each of which has a basis of $1 and is treated as having been 
acquired on Date 1 and 10 shares of Class C stock, each of which has 
a basis of $3 and is treated as having been acquired on Date 2. In 
addition, J has 10 shares of Class D sto