The Service has issued proposed regulations (REG-143686-07) intended to provide a comprehensive approach to stock basis recovery and stock basis identification in transactions to which Section 301 or 302(a) applies. The proposed regulations, which would apply to transactions occurring after the date these regulations are published as final regulations in the Federal Register, have been issued under Sections 301, 302, 304, 351, 354, 356, 358, 368, 861, 1001, and 1016 and provide guidance regarding the recovery of stock basis in distributions under Section 301 and transactions that are treated as dividends to which Section 301 applies, as well as guidance regarding the determination of gain and the basis of stock or securities received in exchange for, or with respect to, stock or securities in certain transactions, such as Section 368 reorganizations.

Proposed Regulations

The primary objective of the proposed regulations is to provide a single model for stock basis recovery by a shareholder that receives a constructive or actual distribution to which Section 301 applies and a single model for sale or exchange transactions to which Section 302(a) applies, including certain elements of a Section 368 reorganization exchange. The proposed regulations would also define the scope of the exchange that must be analyzed under particular Code provisions and provide a methodology for determining gain realized under Section 356 and stock basis under Section 358.

The cornerstone of the proposed regulations is that a share of stock is the basic unit of property that can be disposed of and, as such, the results of a transaction should generally derive from the consideration received in respect of that share. This guiding principle has Section 1012 as its underpinning and has become fundamental to the tax treatment of shareholders, regardless of the specific nature of a shareholder's exchange. A corollary to this premise is that a Section 368 reorganization exchange is not an event that justifies alteration of a shareholder's tax position beyond what is necessary to reflect the results of the reorganization.

The proposed regulations would adopt a single model for Section 301 distributions (dividend equivalent transactions) and a single model for sale or exchange transactions to which Section 302(a) applies (non-dividend equivalent transactions), regardless of whether Section 301 or Section 302(a) applies directly or by reason of Section 302(d), 304 or 356.

Distributions With Respect to Stock and Dividend Equivalent Transactions

Actual Section 301 Distributions

The proposed regulations would treat an actual Section 301 distribution as received on a pro rata, share-by-share basis with respect to the class of stock upon which the distribution is made. Under this rule, a distribution that is not a dividend under Section 301(c)(1) can result in gain for some shares of a class while other shares of that class have unrecovered basis.

Dividend Equivalent Redemptions

These same basis recovery rules would apply to constructive Section 301 distributions, such as to both dividend equivalent redemptions and certain Section 304 transactions. As such, a dividend equivalent redemption would result in a pro rata, share-by-share distribution to all shares of the "redeemed class" the redeemed shareholder held immediately before the redemption. "Redeemed class" would include all of the shares of that class held by the redeemed shareholder.

Constructive Section 301 distributions would be limited to the shares of the redeemed class (instead of constructing a pro rata distribution among all shares of various classes held by the redeemed shareholder) because different classes of stock have distinct legal entitlements that are respected for federal income tax purposes. See H.K. Porter Co., 87 T.C. 689 (1986); Comm'r v. Spaulding Bakeries, 252 F.2d 693 (2d Cir. 1958). The constructive Section 301 distribution is conformed to an actual Section 301 distribution by identifying those shares with respect to which an actual Section 301 distribution would have been received, and by reducing only those shares' bases.

If less than all of the taxpayer's shares of a class of stock are redeemed, the proposed regulations would provide that, in a hypothetical recapitalization described in Section 368(a)(1)(E), the redeemed shareholder is deemed to have exchanged all its shares in the class, including the redeemed shares, for the actual number of shares held after the redemption transaction. Section 358's tracing rules would apply to preserve the basis of the shares exchanged in the recapitalization in the remaining shares of the redeemed class held by the shareholder. Thus, under the proposed regulations, a dividend equivalent redemption is generally treated in the same manner, and its results are the same as a Section 301 distribution in which no shares were cancelled.

Under the proposed regulations, if a shareholder redeems all the shares of a single class in a dividend equivalent redemption, the redeemed shareholder may not shift the basis to other shares it holds (directly or by attribution). In that situation, the proposed regulations would preserve the tax consequences of the unrecovered basis for the redeemed shareholder by treating the amount of the unrecovered basis as a deferred loss of the redeemed shareholder that can be accessed when the conditions of Section 302(b)(1), (2), or (3) are satisfied, or alternatively, when all the shares of the issuing corporation (or its successor) become worthless within the meaning of Section 165(g). The proposed regulations thus depart from current law, which provides that, if all of the shares of a single class of stock held by a shareholder are redeemed in a dividend equivalent redemption, any unrecovered basis in the redeemed shares is permitted to shift to other shares in certain circumstances as provided in Reg. Section 1.302-2(c).

Dividend Equivalent Reorganization Exchanges

If, pursuant to a Section 368 reorganization, a shareholder receives qualifying property and boot in exchange for its target corporation stock, the tax consequences of the receipt of the boot under these proposed regulations would depend upon whether the reorganization exchange is dividend equivalent or not. When determining whether a particular exchange is dividend equivalent, the proposed regulations provide that the overall reorganization exchange is taken into account. As such, if a shareholder exchanges a class of stock solely for boot and another class of stock solely for qualifying property, the overall exchange (the exchange of the two classes of stock for boot and qualifying property) is considered when determining whether each particular exchange is dividend equivalent.

As with the redemption of shares of a redeemed class in a dividend equivalent redemption, a shareholder's receipt solely of boot with respect to a class of stock in a Section 368 reorganization exchange is treated as received pro rata, on a share-by-share basis, with respect to each share in the class, so that the shareholder cannot specify that the boot is received with respect to particular shares within the class. Consequently, such an exchange could result in gain recognition with respect to some shares while other shares in the class could have unrecovered basis.

Special Rules Related to Apportionment of Interest and Other Expenses

Under Section 864(e), taxpayers apportion interest expense between statutory and residual groupings on the basis of the relative values of their assets in each grouping. For this purpose, taxpayers may choose to value their assets using either fair market value or tax book value (adjusted basis). The proposed regulations provide that, for purposes of apportioning expenses on the basis of the tax book value of assets, the adjusted basis in any remaining shares of the redeemed class owned by the redeemed shareholder, any shares that are not in the redeemed class, or any shares owned by certain affiliated corporations are increased by the amount of the unrecovered basis of redeemed shares. As a result, the interest expense allocation and apportionment consequences of a dividend equivalent redemption would be the same as an actual Section 301 distribution under the proposed regulations.

Interaction With Section 1059(e)

Section 1059(e)(1)(A)(iii) states that, except as provided in regulations, in the case of any redemption of stock which would not have been treated (in whole or in part) as a dividend if any options had not been taken into account under Section 318(a)(4), or Section 304(a) had not applied, any amount treated as a dividend is treated as an extraordinary dividend without regard to the taxpayer's holding period in the stock. In the case of these types of redemptions, Section 1059(e)(1)(A) (flush language) provides that only the basis of the stock redeemed shall be taken into account under Section 1059(a). If Section 1059(e)(1)(A)(iii) otherwise applies, the proposed regulations would not affect the basis reduction provided in Section 1059(e)(1)(A). Accordingly, to the extent of an extraordinary dividend under Section 1059(e)(1)(A)(iii), a redeeming shareholder would first reduce basis as prescribed by Section 1059(e)(1)(A), with the proposed regulations then applying to the extent the distribution is not a dividend under Section 301(c)(1).

Redemptions of Stock Held by Partnerships, Trusts, and S Corporation

The treatment of unrecovered basis as a deferred loss raises special issues when the redeemed shareholder is an S corporation, a partnership, or a trust (each a flow-through entity). These proposed regulations reserve with respect to the issues relating to redeemed shareholders that are flow-through entities pending further study and comment.

Redemptions Treated as a Sale or Exchange Under Section 302(a)

For redemptions characterized under Section 302(a), current law permits a shareholder that owns shares of stock with different bases to decide whether to surrender for redemption high-basis shares, low-basis shares, or any combination thereof. The proposed regulations would not limit this electivity and affirm the ability of a shareholder to specify the terms of a Section 368 reorganization exchange when the receipt of boot results in sale or exchange treatment.

If the reorganization exchange is not dividend equivalent, the proposed regulations provide that Section 302(a) would apply to the extent shares are exchanged solely for boot. Under the proposed regulations, just as a shareholder can elect to surrender high-basis shares, low-basis shares, or any combination thereof in a non-dividend equivalent redemption, a shareholder engaging in a Section 368 reorganization exchange that is not dividend equivalent can specify the receipt solely of boot for a share if the terms of the exchange are economically reasonable. The shareholder recognizes gain or loss on that share under Section 302(a), and Section 356(a)(1) will not apply.

Extension of Tracing Principles To Determine Basis in Certain Stock Transfers That Are Not Reorganizations

Application of Tracing Principles to Certain Section 351 Exchanges and Capital Contributions

Current Section 358 regulations apply tracing principles to determine the basis of stock received in a Section 351 exchange only when the exchange also qualifies as a Section 368 reorganization and no liabilities were assumed in the exchange. The principal reason for this limitation is the interaction of the basis tracing rules with the aggregate approach to gain determination under Section 357(c). Although the IRS and Treasury continue to study this issue, the proposed regulations would broaden application of the tracing rules to transfers of stock in Section 351 exchanges in which no liabilities are assumed. As such, in a Section 351 exchange where the transferor transfers two blocks of stock with disparate bases and other property, the separate bases will be preserved under Section 358, provided that liabilities are not assumed in the exchange.

If insufficient shares, or no shares at all, were actually issued in a Section 351 exchange, the proposed regulations would incorporate the deemed issuance and recapitalization approach of the current Section 358 regulations in order to preserve basis. The proposed regulations would also extend the deemed issuance and recapitalization approach to shareholder capital contributions to which Section 118 applies.

Miscellaneous

The proposed regulations would make some clarifying, but nonsubstantive modifications to the current Section 358 regulations. Specifically, the proposed regulations would add headings throughout the current regulations under Regs. Sections 1.358-1 and 1.358-2 without substantive change. The proposed regulations include two new examples illustrating how shareholder elections factor into the terms of an exchange under Section 368. Cross-references are included in the regulations under Sections 368 and 1001 to clarify that, to the extent the terms of the exchange specify that a particular property is received in exchange for a particular property, those terms control for purposes of determining whether a transaction qualifies as a Section 368 reorganization. Consistent with Revenue Ruling 68-55, the proposed regulations provide that, for purposes of determining gain under Section 351(b), the fair market value of each category of consideration received in a Section 351 exchange is allocated between or among the transferred assets based on relative fair market values.

Implications

These proposed regulations provide a comprehensive approach to stock basis recovery and stock basis identification to produce consistent results among economically similar transactions, regardless of the transaction type or the specific Code provision that results in the application of Section 301 or Section 302(a).

These proposed regulations would clarify a number of persistent areas of uncertainty, including those described below.

Section 301 provides rules for the treatment of a distribution with respect to stock but does not specify how to identify the shares upon which a distribution is made. Furthermore, the tax law does not provide rules concerning whether a shareholder recovers its stock basis in the aggregate, or alternatively, whether a shareholder is required to recover stock basis share-by-share. Nor does the tax law provide specifically that transactions treated as Section 301 distributions (redemptions under Section 302(d), certain Section 304 transactions, and certain Section 368 reorganizations) should be subject to the same rules as actual Section 301 distributions. In the Section 368 reorganization context, the Code provides consequences resulting from different types of exchanges, but does not specify whether the exchange is based on a shareholder's aggregate stock holdings, or alternatively, based on particular elements of the overall exchange.

The proposed regulations would help to resolve these uncertainties by providing for a single model for stock basis recovery by a shareholder that receives a constructive or actual distribution to which Section 301 applies and a single model for sale or exchange transactions to which Section 302(a) applies, including certain elements of a Section 368 reorganization exchange.

A negative aspect of the proposed regulations is that the approach they take to extend the tracing regime contained in the current Section 358 regulations to both capital contributions to and distributions from a corporation could lead to burdensome recordkeeping requirements for taxpayers and could prove difficult for the Service to administer.

———————————————