Part IV. Items — Internal Revenue Bulletin 2004-39

Notice of Proposed Rulemaking

Qualified Severance of a Trust for Generation-Skipping Transfer (GST) Tax Purposes

REG–145987–03

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: These proposed regulations provide guidance regarding the qualified severance of a trust for generation-skipping transfer (GST) tax purposes under section 2642(a)(3) of the Internal Revenue Code, which was added to the Code by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The regulations will affect trusts that are subject to the GST tax.

DATES: Written or electronic comments and requests for a public hearing must be received by November 22, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–145987–03), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG–145987–03), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the IRS Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (IRS REG–145987–03).

FOR FURTHER INFORMATION CONTACT: Mayer R. Samuels, (202) 622–3090 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance

with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Rev- enue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by October 25, 2004. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information (see below);

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in §26.2642–6(b). This collection of information is required by the IRS to identify whether a trust is exempt from the GST. This information will be used to determine whether the amount of tax has been calculated correctly. The collection of information is required in order to have a qualified severance. The respondents are trustees of trusts that are being severed.

Estimated total annual reporting burden: 12,500 hours.

Estimated average annual burden hours per respondent: 30 minutes.

Estimated number of respondents: 25,000. Estimated annual frequency of responses: on occasion.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget. Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

Section 2642(a)(3) was added to the Internal Revenue Code by EGTRRA, Public Law 107–16 (115 Stat. 38 (2001)). Under section 2642(a)(3), if a trust is divided into two or more trusts in a “qualified severance,” the resulting trusts will be recognized as separate trusts for GST tax purposes. In many cases, a qualified severance of a trust will facilitate the most efficient and effective use of the transferor’s GST tax exemption. The GST tax exemption is the lifetime exemption applicable in determining the inclusion ratio with respect to the trust, which in turn determines the amount of GST tax imposed on any generation-skipping transfer made from the trust.

Section 2642(a)(3) expands the options for trustees wishing to sever trusts by providing more time to make the severance, providing that severances may occur for more trusts, and providing a uniform system for severance. Section 2642(a)(3) was intended to supercede and replace §26.2654–1(b) of the Generation-Skipping Transfer Tax Regulations, which authorizes the recognition of severed trusts for GST tax purposes in limited situations involving testamentary trusts or inter vivos trusts that are included in the transferor’s gross estate for estate tax purposes. That regulation does not apply to irrevocable inter vivos trusts that are not includible in the decedent’s gross estate. Further, under that regulation, a severance is recognized only if commenced within a prescribed time period, and only if specifically authorized under the terms of the governing instrument or local law.

Section 2642(a)(3)(B)(i) provides a general rule that a qualified severance is

2004–39 I.R.B. 523 September 27, 2004

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.

III. Reporting Requirements

The proposed regulations provide that a qualified severance is to be reported by filing a Form 706–GS(T), “Gener- ation-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 tran

defined as the division of a single trust and the creation of two or more trusts if: (1) the single trust is divided on a fractional basis; and (2) the terms of the new trusts, in the aggregate, provide for the same succession of interests of beneficiaries as are provided in the original trust. Under section 2642(a)(3)(B)(ii), if a trust has an inclusion ratio that is greater than zero and less than one, the trust must be severed in a specified manner that produces one trust that is wholly exempt from GST tax, and one trust that is wholly subject to GST tax. Each of the two new trusts created may be further divided into two or more trusts under section 2642(a)(3)(B)(i). Under section 2642(a)(3)(C), a trustee may elect to sever a trust in a qualified severance at any time, and the manner in which the qualified severance is to be reported is to be specified by regulation. Section 2642(a)(3) is applicable for severances of trusts occurring after December 31, 2000.

Explanation of Provisions

I. Division on a Fractional Basis

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.

II. New Trusts Must Provide for the Same Succession of Interests

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.

September 27, 2004 524 2004–39 I.R.B.

(Passthroughs and Special Industries), IRS. If you have any questions concerning these proposed regulations, please contact Mayer R. Samuels at (202) 622–3090. Other personnel from the IRS and the Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 26 are proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. In §1.1001–1, paragraph (h) is added to read as follows:

§1.1001–1 Computation of gain or loss.

- - - (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 Regis- ter . 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 .

PART 26 — GENERATION-SKIPPING TRANSFER TAX REGULATIONS UNDER THE TAX REFORM ACT OF 1986

Par. 3. The authority citation for part 26 is amended by adding an entry in numerical order to read, in part, as follows:

sition rule applies in the case of severances occurring before the date of publication of the final regulations.

IV. Income Tax Consequences of Severance under the Proposed 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.

V. Proposed Effective Date

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.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that the collection of information imposed by this regulation is not significant as reflected in the estimated burden of information collection for, which is 0.5 hours per respondent, and that few trustees are likely to be small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Requests for Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the substance of the proposed regulations, as well as on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register .

Drafting Information

The principal author of these proposed regulations is Mayer R. Samuels, Office of the Associate Chief Counsel

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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,

Authority: 26 U.S.C. 7805 * * * Section 26.2642–6 also issued under 26 U.S.C. 2642. - * *

Par. 4. In §26.2600–1, the table is amended as follows.

An entry for §26.2642–6 is added.
The entry for §26.2654–1(b) introductory text is revised.
An entry for §26.2654–1(c) is added. The revision and additions read as follows:

§26.2600–1 Table of contents.

§26.2642–6 Qualified severance.

(a) In general. (b) Requirements for a qualified severance.

(d) Irrevocable trusts. (e) Examples. (f) Effective date.

§26.2654–1 Certain trusts treated as separate trusts.

- - - (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:

§26.2642–6 Qualified severance

(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 sever- ance . 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

September 27, 2004 526 2004–39 I.R.B.

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 sever- ance . 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 Genera- tion-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 sepa

rate 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 in- come 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

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 in- come 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% in- clusion 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 Cor

2004–39 I.R.B. 527 September 27, 2004

poration 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:

The paragraph heading for (b) and the introductory text of paragraph (b)(1) are revised.
Paragraph (c) is added. The revision and addition reads as follows:

§26.2654–1 Certain trusts treated as separate trusts.

- - - (b) Division of a trust included in the gross estate occurring on or before De- cember 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.

Deborah M. Nolan, Acting Deputy Commissioner for

Services and Enforcement.

(Filed by the Office of the Federal Register on August 23, 2004, 8:45 a.m., and published in the issue of the Federal Register for August 24, 2004, 69 F.R. 51967)

Notice of Proposed Rulemaking and Notice of Public Hearing

LIFO Recapture Under Section 1363(d)

REG–149524–03

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations regarding LIFO recapture by corporations converting from C corporations to S corporations. The purpose of the proposed regulations is to provide guidance on the LIFO recapture requirement when the corporation holds inventory accounted for under the last-in, first-out (LIFO) method (LIFO inventory) indirectly through a partnership. The proposed regulations affect C corporations that own interests in partnerships holding LIFO inventory and that elect to be taxed as S corporations or that transfer such partnership interests to S corporations in nonrecognition transactions. The proposed regulations also affect S corporations receiving such partnership interests from C corporations in nonrecognition transactions.

DATES: Written or electronic comments must be received by November 12, 2004. Requests to speak and outlines of topics to

September 27, 2004 528 2004–39 I.R.B.

Background

This document contains proposed amendments to 26 CFR Part 1 under section 1363(d) of the Internal Revenue Code (Code). Section 1363(d)(1) provides that a C corporation that owns LIFO inventory and that elects under section 1362(a) to be taxed as an S corporation must include in its gross income for its final tax year as a C corporation the LIFO recapture amount. Under section 1363(d)(3), the LIFO recapture amount is the excess of the inventory amount of the inventory using the first-in, first-out (FIFO) method (the FIFO value) over the inventory amount of the inventory using the LIFO method (the LIFO value) at the close of the corporation’s final tax year as a C corporation (essentially, the amount of income the corporation has deferred by using the LIFO method rather than the FIFO method).

Final regulations (T.D. 8567, 1994–2 C.B. 199) under section 1363(d) were published in the Federal Register on October 7, 1994 (59 FR 51105) to describe the recapture of LIFO benefits when a C corporation that owns LIFO inventory elects to become an S corporation or transfers LIFO inventory to an S corporation in a nonrecognition transaction. The final regulations do not explicitly address the indirect ownership of inventory through a partnership. These proposed regulations provide guidance for situations in which a C corporation that owns LIFO inventory through a partnership (or through tiered partnerships) converts to an S corporation or transfers its partnership interest to an S corporation in a nonrecognition transaction.

Section 1374, modified as part of the repeal of the General Utilities doctrine, see General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), imposes a corporate level tax on certain income or gain recognized by an S corporation to the extent the income or gain is attributable to appreciation that occurred while the assets were held by a C corporation. Specifically, section 1374 imposes a corporate level tax on an S corporation’s net recognized built-in gain attributable to assets that it held on the date it converted from a C corporation to an S corporation. The tax is imposed only during the 10-year period beginning on the first day the corporation is an S corporation. In addition, sec

be discussed at the public hearing scheduled for Wednesday, December 8, 2004, must be received by Wednesday, November 17, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–149524–03), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG–149524–03), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or submitted electronically via the IRS Internet site at: http://www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (IRS and REG–149524–03).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Pietro Canestrelli, 202–622–3060, or Martin Schäffer, 202–622–3070; concerning submissions, Robin Jones, 202–622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Ser- vice, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by October 12, 2004. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the Internal Revenue Service, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information (see below);

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information can be minimized, including through the application of automated collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in §1.1363–2(e)(3). This information is required to inform the IRS of partnerships electing to increase the basis of inventory to reflect any amount included in a partner’s income under section 1363(d). Thus, the collection of information is required to obtain a benefit. The likely respondents are businesses or other for-profit institutions.

The burden for the collection of information in §1.1363–2(e)(3) is reflected on Form 1065, “ U.S. Return of Partnership Income .”

The estimated burden for the collection of information in §1.1363–2(e)(3) is as follows:

Estimated total annual reporting burden: 200 hours.

The estimated annual burden per respondent varies from 1 to 3 hours, depending on individual circumstances, with an estimated average of 2 hours.

Estimated number of respondents: 100. Estimated annual frequency of responses: On occasion.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

2004–39 I.R.B. 529 September 27, 2004

through a partnership must increase its basis in its partnership interest by the lookthrough LIFO recapture amount. The proposed regulations also allow the partnership through which the LIFO inventory is owned to adjust the basis of partnership inventory (or lookthrough partnership interests held by that partnership) to account for LIFO recapture. This adjustment to basis is to be patterned in manner and effect after the adjustment in section 743(b). Thus, the basis adjustment constitutes an adjustment to the basis of the LIFO inventory (or lookthrough partnership interests held by that partnership) with respect to the corporate partner only; no adjustment is made to the partnership’s common basis. The IRS and the Treasury Department request comments on whether the partnership should be required, in some or all circumstances, to increase the basis of partnership assets by the lookthrough LIFO recapture amount attributable to those assets.

Under §1.1374–4(i)(1), an S corporation’s distributive share of partnership items is not taken into account in determining the S corporation’s share of net recognized built-in gain or loss if the S corporation’s partnership interest represents less than 10 percent of the partnership capital and profits and has a fair market value of less than $100,000. This exception reduces the burden on the S corporation and the partnership of tracking built-in gain assets that are relatively small in amount.

The burden of looking through a partnership interest under section 1374 is greater than the burden of looking through a partnership interest under section 1363(d). Under section 1374, partnership assets must be tracked for a 10-year period. No such tracking problem exists under section 1363 because recapture generally occurs on the date of the S election. Accordingly, the proposed regulations do not contain an exception for partnership interests that are smaller than a specified threshold.

Proposed Effective Date

These regulations are proposed to apply to S elections and transfers made on or after August 13, 2004. No inference is intended as to the tax consequences of S elections and transfers made before the effective date of these regulations.

tion 1374 imposes a corporate level tax on an S corporation’s net recognized built-in gain attributable to assets that the S corporation acquires if the S corporation’s bases in such assets are determined (in whole or in part) by reference to the bases of such assets (or any other property) in the hands of a C corporation. This tax is imposed only during the 10-year period beginning on the date that the S corporation acquires the assets.

In Announcement 86–128, 1986–51 I.R.B. 22, the IRS stated that, for purposes of section 1374(d)(2)(A), the inventory method used by a taxpayer for tax purposes (FIFO, LIFO, etc.) shall be used in determining whether goods disposed of following a conversion from C corporation to S corporation status were held by the corporation at the time of conversion. After the issuance of this announcement, Congress became concerned that taxpayers owning LIFO inventory might avoid the built-in gain rules of section 1374. Congress believed that taxpayers owning LIFO inventory, who have enjoyed the deferral benefits of the LIFO method during their status as a C corporation, should not be treated more favorably than their FIFO counterparts. To eliminate this potential disparity in treatment, Congress enacted section 1363(d) in 1987, requiring a taxpayer owning LIFO inventory to recapture the benefits of using the LIFO method. H.R. Rep. No. 100–391 (Parts 1 and 2), 1098 (1987). In Coggin Automotive Corp. v. Com- missioner, 292 F.3d 1326 (11 ^th Cir. 2002), rev’g 115 T.C. 349 (2000), a holding company owned majority interests in several subsidiaries that operated automobile dealerships owning LIFO inventory. As part of a restructuring, each subsidiary contributed its assets (including its LIFO inventory) to a different partnership. The subsidiaries were then merged into the holding company, which elected to be taxed as an S corporation. The court of appeals held that the holding company’s S corporation election did not trigger LIFO recapture under section 1363(d) because it was the partnerships in which the holding company held interests, and not the holding company itself, that used the LIFO method.

Section 337(d)(1) authorizes the Secretary to prescribe regulations to prevent the circumvention of the purposes of the

repeal of the General Utilities doctrine through the use of any provision of law or regulations. The Treasury Department and the IRS believe that these proposed regulations are necessary to implement General Utilities repeal. Congress enacted section 1363(d) because the use of the LIFO method by a C corporation that converts to S corporation status creates the potential for the permanent avoidance of corporate level tax on the built-in gain reflected in the LIFO reserve. This avoidance possibility is present regardless of whether the converting corporation owns inventory directly or indirectly through a partnership or tiered partnerships. Accordingly, the Treasury Department and the IRS believe it is appropriate to require the recapture of a converting corporation’s share of the LIFO reserves of partnerships in which it participates. Such an approach is consistent with the regulations under section 1374, which generally adopt a lookthrough approach to partnerships.

Explanation of Provisions

The proposed regulations provide that a C corporation that holds an interest in a partnership owning LIFO inventory must include the lookthrough LIFO recapture amount in its gross income where the corporation either elects to be an S corporation or transfers its interest in the partnership to an S corporation in a nonrecognition transaction. The proposed regulations define the lookthrough LIFO recapture amount as 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 FIFO value. A corporate partner’s lookthrough LIFO recapture amount must be determined, in general, as of the day before the effective date of the S corporation election or, if the recapture event is a transfer of a partnership interest to an S corporation, the date of the transfer (the recapture date). The proposed regulations provide that, if a partnership is not otherwise required to determine inventory values on the recapture date, the lookthrough LIFO recapture amount may be determined based on inventory values of the partnership’s opening inventory for the year that includes the recapture date.

The proposed regulations provide that a corporation owning LIFO inventory

September 27, 2004 530 2004–39 I.R.B.

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 part- nership 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

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in EO 12866; therefore, a regulatory assessment is not required. It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that few corporations engage in the type of transactions that are subject to these regulations (the conversion from C corporation to S corporation status while holding an interest in a partnership that owns LIFO inventory or the transfer of an interest in such a partnership by a C corporation to an S corporation in a nonrecognition transaction). Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for Wednesday, December 8, 2004, beginning at 10:00 a.m. in the auditorium of the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit electronic or written comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by Wednesday, November 17, 2004. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal authors of these regulations are Martin Schäffer and Pietro Canestrelli, Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and the Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805. - * * Section 1.1363–2 also issued under 26 U.S.C. 337(d). - * *

Par. 2. Section 1.1363–2 is amended by:

Redesignating paragraphs (b), (c), and (d) as paragraphs (d), (e), and (g), respectively.
Adding paragraphs (b), (c), (f), and (g)(3).
Revising newly designated paragraphs (d) and (e).

The revisions and additions read as follows:

§1.1363–2 Recapture of LIFO benefits.

- - - (b) LIFO inventory held indirectly through partnership . A C corporation

2004–39 I.R.B. 531 September 27, 2004

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.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement.

(Filed by the Office of the Federal Register on August 12, 2004, 8:45 a.m., and published in the issue of the Federal Register for August 13, 2004, 69 F.R. 50109)

September 27, 2004 532 2004–39 I.R.B.

Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulations and Notice of Public Hearing

Clarification of Definitions

REG–124872–04

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary regulations and notice of public hearing.

SUMMARY: This issue of the Bulletin contains temporary regulations (T.D. 9153) that provide clarification of the definitions of a corporation and a domestic entity in circumstances where the business entity is considered to be created or organized in more than one jurisdiction. These regulations will affect business entities that are created or organized under the laws of more than one jurisdiction. The text of those temporary regulations also serves as the text of these proposed regulations. This document also provides a notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments and must be received by November 10, 2004. Requests to speak and outlines of topics to be discussed at the public hearing scheduled for November 3, 2004, must be received by October 15, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–124872–04), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may also be hand-delivered Monday through Friday (excluding Federal holidays) between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–124872–04), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via either the IRS internet site at www.irs.gov/regs or the Federal eRulemaking Portal at www.regulations.gov (IRS and REG–124872–04). The public hearing will be held in the Auditorium,

Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Thomas Beem, (202) 622–3860; concerning submissions of comments or the public hearing, Sonya Cruse, (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

Temporary regulations in this issue of the Bulletin amend 26 CFR part 301 relating to section 7701 of the Internal Revenue Code of 1986 (Code). The temporary regulations provide guidance as to the definitions of a corporation and of domestic and foreign entities in circumstances in which an entity is created or organized under the laws of more than one jurisdiction (a dually chartered entity). The text of those regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations explains both the temporary regulations and these proposed regulations.

Special Analyses

Comments and Public Hearing

comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for November 3, 2004, at 10:00 a.m. in the Auditorium of the Internal Revenue building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area earlier than 30 minutes prior to the start of the hearing. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to this hearing. Persons who wish to present oral comments at the hearing must submit electronic or written comments and an outline of the topics to be discussed and the time devoted to each topic (signed original and eight (8) copies) by October 15, 2004. A period of ten minutes will be allotted to each person for making comments. An agenda showing the scheduling of speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Proposed Effective Date

The regulations proposed in this document would apply on August 12, 2004, to all business entities existing on or after that date.

Drafting Information

The principal author of these proposed regulations is Thomas Beem of the Office of Associate Chief Counsel (International). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 301 is proposed to be amended as follows:

2004–39 I.R.B. 533 September 27, 2004

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by October 12, 2004. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the Internal Revenue Service, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information (see below);

How the quality, utility, and clarity of the information to be collected may be enhanced;

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of service to provide information.

The collection of information in this proposed regulation is in §1.752–2(k). This information is required to ensure proper allocations of partnership liabilities. This information will be used to determine the extent to which certain partners or related persons bear the economic risk of loss with respect to partnership liabilities. The collection of information is mandatory. The likely reporters are individuals and small businesses or organizations.

Estimated total annual reporting burden: 500 hours.

The estimated annual burden per respondent varies from 6 minutes to 2 hours,

PART 301 - PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. In §301.7701–1, paragraph (d) is revised to read as follows:

§301.7701–1 Classification of organizations for federal tax purposes.

- - - (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:

§301.7701–2 Business entities; definitions.

- - - (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:

§301.7701–5 Domestic and foreign business entities.

[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.]

Mark E. Matthews, Deputy Commissioner for Services and Enforcement .

(Filed by the Office of the Federal Register on August 11, 2004, 8:45 a.m., and published in the issue of the Federal Register for August 12, 2004, 69 F.R. 49840)

Notice of Proposed Rulemaking

Treatment of Disregarded Entities Under Section 752

REG–128767–04

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: The proposed regulations provide rules under section 752 for taking into account certain obligations of a business entity that is disregarded as separate from its owner under sections 856(i), 1361(b)(3), or §§301.7701–1 through 301.7701–3 (disregarded entity) for purposes of characterizing and allocating partnership liabilities. The rules affect partnerships with partnership debt and partners in those partnerships. These proposed regulations clarify the existing regulations concerning when a partner may be treated as bearing the economic risk of loss for a partnership liability based upon an obligation of a disregarded entity.

DATES: Written or electronic comments and requests for a public hearing must be received by November 11, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–128767–04), room 5203, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may also be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG–128767–04), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the IRS Internet site at: www.irs.gov/regs, or via the Federal eRulemaking Portal at: www.regula- tions.gov (IRS-REG–128767–04).

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Michael J. Goldman, (202) 622–3070; concerning submissions of the comments and the public hearing, Robin Jones, (202) 622–3521 (not toll-free numbers).

September 27, 2004 534 2004–39 I.R.B.

the partnership determines the partner’s share of partnership liabilities pursuant to §§1.752–4(d) and 1.705–1(a). However, the proposed regulations 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 §1.752–2(b)(1)) with respect to such obligation of the disregarded entity.

Under the proposed regulations, the net value of a disregarded entity equals the fair market value of all assets owned by the disregarded entity that may be subject to creditors’ claims under local law, including the disregarded entity’s enforceable rights to contributions from its owner but excluding the disregarded entity’s interest in the partnership (if any) and the fair market value of property pledged to secure a partnership liability (which is already taken into account under §1.752–2(h)(1)), less obligations of the disregarded entity that do not constitute, and are senior or of equal priority to, payment obligations of the disregarded entity. After the net value of a disregarded entity is initially determined under the rules of the proposed regulations, the net value of the disregarded entity is not redetermined unless the obligations of the disregarded entity that do not constitute, and are senior or of equal priority to, payment obligations of the disregarded entity change by more than a de minimis amount or there is more than a de minimis contribution to or distribution from the disregarded entity. The IRS and Treasury Department request comments on whether other events (such as a sale of substantially all of a disregarded entity’s assets) should be specified as revaluation events and whether a partner should be able to make an election to revalue a disregarded entity annually regardless of the occurrence of a revaluation event. An election to revalue annually would be revocable only with the Commissioner’s consent.

The proposed regulations also provide that the net value of a disregarded entity is determined by taking into account a subsequent reduction in the net value of the entity if the subsequent reduction is anticipated and 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. In addition, under the proposed regulations, if one or more disregarded entities have

depending on individual circumstances, with an estimated average of 1 hour.

Estimated number of respondents: 500. Estimated frequency of responses: On occasion.

Background

Under section 752, a partner’s basis in its partnership interest includes the partner’s share of partnership liabilities. The Income Tax Regulations under section 752 provide rules relating to the determination of a partner’s share of partnership liabilities. Those rules differ depending upon whether the liability is characterized as recourse or nonrecourse for purposes of section 752. Section 1.752–1(a) provides that a partnership liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability under §1.752–2. Section 1.752–1(a) also provides that a partnership liability is a nonrecourse liability to the extent that no partner or related person bears the economic risk of loss for that liability under §1.752–2.

In general, a partner bears the economic risk of loss for a partnership liability under §1.752–2 to the extent that the partner or a related person (as defined in §1.752–4(b)) has an obligation to make a payment to any person, including a contribution to the partnership, that is recognized under §1.752–2(b)(3) on account of the partnership liability if the partnership were to constructively liquidate as described in §1.752–2(b) (payment obligation). As provided in §1.752–2(b)(3) and (5), all statutory and contractual obligations relating to the partnership liability and reimbursement rights are taken into account in determining whether a partner or related person has a payment obligation under §1.752–2(b). Moreover, for purposes of determining the extent to which a partner

or related person has a payment obligation and the economic risk of loss for a partnership liability, §1.752–2(b)(6) provides that it is presumed that all partners and related persons who have obligations to make payments actually perform those obligations, irrespective of their actual net worth (presumption of deemed satisfaction), unless the facts and circumstances indicate a plan to circumvent or avoid the obligation.

These proposed regulations clarify the existing regulations concerning when a partner may be treated as bearing the economic risk of loss for a partnership liability based upon a payment obligation of a business entity that is disregarded as separate from its owner under sections 856(i), 1361(b)(3), or §§301.7701–1 through 301.7701–3 of this chapter (disregarded entity). Because a disregarded entity and its owner are treated as a single entity, the presumption of deemed satisfaction of obligations undertaken by the owner arguably should include payment obligations undertaken by the disregarded entity. However, because of statutory limitations on liability, the owner of a disregarded entity may have no obligation to satisfy payment obligations undertaken by the disregarded entity. The current regulations consider such limitations on the payment obligations of a partner or related person to be relevant in determining the extent to which the partner or related person is treated as bearing the economic risk of loss for a partnership liability. The IRS and Treasury Department believe that because only the assets of a disregarded entity may be available to satisfy payment obligations undertaken by the disregarded entity, a partner should be treated as bearing the economic risk of loss for a partnership liability as a result of those payment obligations only to the extent of the net value of the disregarded entity’s assets.

Explanation of Provisions

The proposed regulations provide that in determining the extent to which a partner bears the economic risk of loss for a partnership liability, payment obligations of a disregarded entity are taken into account for purposes of section 752 only to the extent of the net value of the disregarded entity as of the date on which

2004–39 I.R.B. 535 September 27, 2004

(Passthroughs and Special Industries). Other personnel from the Treasury Department and the IRS participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.704–2 is amended as follows:

Paragraph (f)(2) is revised.
The first sentence of paragraph (g)(3) is revised.
The third sentence of paragraph (i)(4) is revised.
Paragraph (l)(1)(iv) is added. The revisions and addition read as follows:

§1.704–2 Allocations attributable to nonrecourse liabilities.

- - - (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

payment obligations 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.

To facilitate the partnership’s determination of the net value of a disregarded entity, the proposed regulations provide that a partner that may be treated as bearing the economic risk of loss for a partnership liability based upon a payment obligation of a disregarded entity must provide information as to the entity’s tax classification and net value to the partnership on a timely basis.

The IRS and Treasury Department are considering and request comments regarding whether the rules of the proposed regulations should be extended to the payment obligations of other entities, such as entities that are capitalized with nominal equity.

The proposed regulations also include conforming changes to §1.704–2(f)(2), (g)(3) and (i)(4). Section 1.704–2 includes rules that apply when the character of partnership debt under section 752 changes as a result of a guarantee, lapse of a guarantee, conversion, refinancing or other change in the debt instrument. Under the proposed regulations, those rules would apply upon any change in the character of partnership debt under section 752, whether as a result of the circumstances specified in the current regulations or as a result of changes under the rules of the proposed regulations.

Finally, the proposed regulations clarify that the pledge rules of the regulations under §1.752–2(h) refer to the net fair market value of property pledged to secure a partnership liability. The IRS and Treasury Department are considering and request comments regarding whether partners should be able to make an election, revocable only with the Commissioner’s consent, to revalue pledged assets annually.

Proposed Effective Date

The regulations are proposed to 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.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that the amount of time necessary to report the required information will be minimal. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and 8 copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules, how they can be made easier to understand and the administrability of the rules in the proposed regulations. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by any person who timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place of the public hearing will be published in the Federal Register .

Drafting Information

The principal author of these proposed regulations is Michael J. Goldman of the Office of Associate Chief Counsel

September 27, 2004 536 2004–39 I.R.B.

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 min- imis amount or there is more than a de min- imis 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 disre- garded 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

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 Fed- eral Register, (see 26 CFR part 1 revised as of April 1, 2004).
- - - Par. 3. Section 1.752–2 is amended as follows:

Paragraph (a) is revised.
The last sentence of paragraph (b)(6) is revised.
Paragraph (h)(3) is revised.
Paragraphs (k) and (l) are added. The revisions and additions read as follows:

§1.752–2 Partner’s share of recourse liabilities.

(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

2004–39 I.R.B. 537 September 27, 2004

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 part- nership 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).

Nancy Jardini, Acting Deputy Commissioner for

Services and Enforcement.

(Filed by the Office of the Federal Register on August 11, 2004, 8:45 a.m., and published in the issue of the Federal Register for August 12, 2004, 69 F.R. 49832)

Notice of Proposed Rulemaking

Corporate Reorganizations; Transfers of Assets or Stock Following a Reorganization

REG–130863–04

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations that provide guidance regarding the effect of certain transfers of assets or stock on the qualification of certain transactions as reorganizations under section 368(a). This document also contains proposed regulations that provide guidance on the continuity of business enterprise requirement and the definition of a party to a reorganization. These regulations affect corporations and their shareholders.

DATES: Written or electronic comments must be received by November 15, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–130863–04), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–130863–04), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the IRS Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (IRS REG–130863–04).

September 27, 2004 538 2004–39 I.R.B.

sets 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).

B. Contributions to Partnerships

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

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jeffrey B. Fienberg, (202) 622–7770; concerning submissions and the hearing, LaNita Van Dyke, (202) 622–3215 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

On March 2, 2004, the IRS and Treasury Department published in the Fed- eral Register (69 FR 9771) a notice of proposed rulemaking (REG–165579–02, 2004–13 I.R.B. 651) that would amend §1.368–2(k) to provide that a reorganization otherwise qualifying under section 368(a) will not be disqualified as a result of the transfer or successive transfers to one or more corporations controlled in each transfer by the transferor corporation of part or all of (i) the assets of any party to the reorganization or (ii) the stock of any party to the reorganization other than the issuing corporation (hereinafter the March 2004 proposed regulations). The March 2004 proposed regulations also include amendments to the continuity of business enterprise (COBE) regulations under §1.368–1(d) and the definition of a party to a reorganization under §1.368–2(f).

While the March 2004 proposed regulations address transfers of assets and stock to corporations controlled by the transferor corporation, they do not address whether a transaction that otherwise qualifies as a reorganization continues to qualify when, pursuant to the plan of reorganization, assets or stock of the acquired corporation is distributed to a corporation or partnership following the reorganization. In addition, they do not provide guidance on whether a transaction that otherwise qualifies as a reorganization continues to qualify when, pursuant to the plan of reorganization, acquired assets are transferred to a partnership in which the transferor owns an interest. These proposed regulations expand the March 2004 regulations to address these situations.

The IRS and Treasury Department received comments regarding the March 2004 proposed regulations. Comments not addressed in this document are still being considered.

A. Distributions

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 as

2004–39 I.R.B. 539 September 27, 2004

tion 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 33 ¹ /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.

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.

C. Effective Date

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 .

Special Analyses

Comments and Requests for Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register .

Drafting Information

The principal author of these proposed regulations is Jeffrey B. Fienberg of the Office of Associate Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.368–1 is amended as follows:

The text of paragraph (d)(4)(i) is redesignated as paragraph (d)(4)(i)(A) and a paragraph heading is added for (d)(4)(i)(A).
Paragraph (d)(4)(i)(B) is added.
The text of paragraph (d)(5) is redesignated as paragraph (d)(5)(i), and revised.
In newly designated paragraph (d)(5)(i), Examples 7 through 12 are redesignated as Examples 8 through 13, respectively.
In newly designated paragraph (d)(5)(i), a new Example 7 is added.
In newly designated paragraph (d)(5)(i), paragraph (i) in resdesignated Example 9, paragraph (i) in redesignated Example 10, and the first sentence in paragraph (i) in redesignated Example 12 are revised.
Paragraph (d)(5)(ii) is added. The revisions and additions read as follows:

§1.368–1 Purpose and scope of exception of reorganization exchanges.

- - - (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 reorganiza

September 27, 2004 540 2004–39 I.R.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 sec- tion 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

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. - * *

- - - (ii) Effective dates . Paragraph (d)(5) Example 6 and Example 8 through Exam- ple 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 .
- - - Par. 3. Section 1.368–2 is amended by:

Adding three sentences at the end of paragraph (f).
Revising paragraphs (j)(3)(ii) and (iv).
Removing the first sentence of paragraph (j)(3)(iii) and adding two new sentences.
Revising paragraph (k). The additions and the revision read as follows:

§1.368–2 Definition of terms.

- - - (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 Regis- ter . 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);

2004–39 I.R.B. 541 September 27, 2004

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 33 ¹ /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 corpora- tion stock to controlled corporations after a reorgani- zation 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 .

Deborah M. Nolan, Acting Deputy Commissioner for

Services and Enforcement.

(Filed by the Office of the Federal Register on August 17, 2004, 8:45a.m., and published in the issue of the Federal Register for August 18, 2004, 69 F.R. 51209)

Withdrawal of Proposed Regulations Relating to Corporate Reorganizations; Transfers of Assets or Stock Following a Reorganization

Announcement 2004–69

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking.

SUMMARY: This document withdraws a notice of proposed rulemaking (REG–165579–02, 2004–13 I.R.B. 651) regarding the effect of certain transfers of assets or stock on the qualification of certain transactions as reorganizations under section 368(a). The proposed regulations were published on March 2, 2004. After consideration of additional issues related to the effect of transfers of assets or stock on the qualification of a transaction as a reorganization, the IRS and Treasury Department have decided to withdraw the proposed regulations and issue new proposed regulations that provide a more complete set of rules addressing such transfers.

DATES: These proposed regulations are withdrawn August 17, 2004.

FOR FURTHER INFORMATION CONTACT: Jeffrey B. Fienberg (202) 622–7770 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Background

On March 2, 2004, the IRS and Treasury Department issued proposed regulations regarding the effect of certain transfers of assets or stock on the qualification of certain transactions as reorganizations under section 368(a) (69 FR 9771) (hereinafter the March 2004 proposed regulations). After consideration of additional issues related to the effect of transfers of assets or stock on the qualification of a transaction as a reorganization, including distributions of assets or stock after purported reorganizations, the IRS and Treasury Department have decided to withdraw the March 2004 proposed regulations and

September 27, 2004 542 2004–39 I.R.B.

The principal author of this announcement is Barbara Franklin of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further information regarding this announcement, contact Ms. Franklin at (202) 622–3130 (not a toll-free call).

Section 1045 Application to Partnerships; Hearing

Announcement 2004–73

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Change in date of public hearing; extension of time to submit outlines of oral comments.

SUMMARY: This document changes the date of the public hearing on the notice of proposed rulemaking (REG–150562–03, 2004–32 I.R.B. 175) that relates to the application of section 1045 of the Internal Revenue Code (Code) to partnerships and their partners. It also extends the time to submit outlines of oral comments for the hearing.

DATES: The public hearing originally scheduled for November 2, 2004, at 10 a.m. will be held November 9, 2004, at 10 a.m. Additional outlines of oral comments must be received by October 19, 2004.

ADDRESSES: The public hearing will be held in the Auditorium, Internal Revenue Service Building, 1111 Constitution Avenue, NW, Washington, DC. Send submissions to: CC:PA:LPD:PR (REG–150562–03), Room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–150562–03), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the IRS Internet site at http://www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (IRS and REG–150562–03).

issue new proposed regulations that provide a more complete set of rules addressing such transfers. Accordingly, the March 2004 proposed regulations are withdrawn.

Drafting Information

The principal author of this withdrawal notice is Jeffrey B. Fienberg of the Office of Associate Chief Counsel (Corporate).

- - - -

Withdrawal of Notice of Proposed Rulemaking

Accordingly, under the authority of 26 U.S.C. 7805, the notice of proposed rulemaking (REG–165579–02) published in the Federal Register on March 2, 2004 (69 FR 9771), is hereby withdrawn.

Deborah M. Nolan, Acting Deputy Commissioner for

Services and Enforcement.

(Filed by the Office of the Federal Register on August 16, 2004, 8:45 a.m., and published in the issue of the Federal Register for August 17, 2004, 69 F.R. 51026)

Penalty Relief Under Section 6715

Announcement 2004–70

The Internal Revenue Service will not assert the penalty under section 6715 of the Internal Revenue Code with respect to dyed diesel fuel that, due to shortages of clear diesel fuel in the State of Florida caused by Hurricanes Charley and Frances, has been delivered by wholesale dealers to retail dealers for resale to highway users or has been sold by wholesale dealers directly to end users for highway use. This relief from the section 6715 penalty will apply only to dyed diesel fuel that wholesale dealers deliver or sell in the State of Florida and only to fuel delivered or sold by wholesale dealers during the period September 2, 2004, through September 15, 2004. In the case of wholesale dealers, penalty relief will be available only if the wholesale dealer reports and pays the tax on the dyed diesel fuel that is delivered or sold for highway

use. The return and payment will be due on October 31, 2004, and the IRS will not assert penalties for failure to make semimonthly deposits of the tax. Wholesale dealers should call 1–866–699–4096 (a toll-free number) for instructions on the proper method for reporting and paying this tax.

In general, diesel fuel may be removed tax free from a terminal if it is dyed in the manner specified in the regulations under section 4082 of the Internal Revenue Code. Section 4081(b) of the Internal Revenue Code imposes a tax on blended diesel fuel created by mixing dyed diesel fuel with clear diesel fuel that has been previously taxed. Under regulations, the seller of the dyed fuel in the mixture is liable for this tax if the dyed fuel is sold as fuel that has previously been taxed. A sale of dyed diesel fuel by a wholesaler to a retailer will be treated as meeting this condition if the wholesaler delivers the dyed fuel into the retailer’s storage tank for clear diesel fuel and the fuel qualifies for relief from the section 6715 penalty. Section 4041(a) of the Internal Revenue Code imposes a tax on sales of dyed diesel fuel that has not been previously taxed to persons that will use the fuel in a taxable highway use. Section 6715 of the Internal Revenue Code imposes a penalty if dyed diesel fuel is sold for highway use or is knowingly used on the highway.

Recent and imminent hurricanes in Florida have resulted in critical shortages of clear, low-sulfur diesel fuel in that State. The Internal Revenue Service and the Environmental Protection Agency are concerned that these shortages could impair the ability of emergency vehicles and utility repair vehicles to respond to existing damage from Hurricane Charley and expected damage from Hurricane Frances. Although limited quantities of dyed, high-sulfur diesel fuel are also available in Florida, Clean Air Act restrictions and the section 6715 penalty restrict this fuel to nontaxable off-highway uses. The relief announced today by the Internal Revenue Service and the Environmental Protection Agency’s exercise of its enforcement discretion under the Clear Air Act restrictions will make all diesel fuel in the State of Florida available for highway use.

2004–39 I.R.B. 543 September 27, 2004

Cynthia E. Grigsby, Acting Chief, Publications

and Regulations Branch, Legal Processing Division,

Associate Chief Counsel (Procedures and Administration) .

(Filed by the Office of the Federal Register on September 1, 2004, 8:45 a.m., and published in the issue of the Federal Register for September 2, 2004, 69 F.R. 53664)

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Charlotte Chyr, (202) 622–3070, or Jian H. Grant, (202) 622–3050; concerning submissions, the hearing, and/or placement on the building access list to attend the hearing, Sonya M. Cruse of the Publications and Regulations Branch, Legal Processing Division, Associate Chief Counsel (Procedures and Administration), at (202) 622–4693 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Backgrounds

A notice of proposed rulemaking and notice of public hearing, appearing in the

Federal Register on Thursday, July 15, 2004, (69 FR 42370), announced that a public hearing on the notice of proposed rulemaking relating to the application of section 1045 of the Internal Revenue Code (Code) to partnerships and their partners would be held on November 2, 2004, in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Subsequently, the date of the public hearing has been changed to November 9, 2004, at 10 a.m. in the IRS Auditorium. Outlines of oral comments must be received by October 19, 2004.

September 27, 2004 544 2004–39 I.R.B.