Paragraph 1. The authority citation for part 1 is amended by revising the entry for “Section 1.351-1” to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.351-1 also issued under 26 U.S.C. 351. * * *

Par. 2. Section 1.332-2 is amended by:

1. Revising the first sentence of paragraph (a).

2. Revising paragraph (b).

3. Revising the heading of the Example in paragraph (e).

4. Adding Example 2 to paragraph (e).

The revisions and addition read as follows:

Example 2. P Corporation owns all of the outstanding preferred and common stock of Q Corporation. The preferred stock is not stock described in section 1504(a)(4). The fair market value of Q Corporation’s assets exceeds the amount of its liabilities but does not exceed the liquidation preference on the Q Corporation’s preferred stock. Q Corporation liquidates and distributes all of its assets to P Corporation. P Corporation receives partial payment for its Q Corporation preferred stock but receives nothing for its Q Corporation common stock. The receipt by P Corporation of the properties of Q Corporation is not a distribution received by P Corporation in complete liquidation of Q Corporation within the meaning of section 332. Thus, under section 165(g), P Corporation is entitled to a worthless security deduction for its Q Corporation common stock. The transaction may qualify as a reorganization under section 368(a)(1)(C). If the transaction does not qualify as a reorganization, P Corporation will recognize gain or loss on its Q Corporation preferred stock under section 331.

(b) Section 332 applies only when the recipient corporation receives at least partial payment for each class of stock that it owns in the liquidating corporation. If section 332 does not apply, see section 165(g) regarding the allowance of losses for worthless securities for a class of stock for which no payment is received. Further, if section 332 does not apply and the recipient corporation receives partial payment for at least one class of stock that it owns in the liquidating corporation, see section 368(a)(1) regarding potential qualification of the distribution as a reorganization. If section 332 does not apply and the distribution does not qualify as a reorganization, see section 331 for those classes of stock for which partial payment is received.

(b)(1) When property is transferred to a corporation by two or more persons in exchange for stock, as described in paragraph (a) of this section, and the stock received is received in disproportion to the transferor’s prior interest in such property, the entire transaction will be given tax effect in accordance with its true nature, and the transaction may be treated as if the stock had first been received in proportion and then some of such stock had been used to make gifts (section 2501 et seq.), to pay compensation (sections 61(a)(1) and 83(a)), or to satisfy obligations of the transferor of any kind.

Example 4. A, an individual, transfers an apartment building with a fair market value of $175x to Corporation X. The building is subject to a nonrecourse obligation of $190x and no other asset is subject to that liability. A receives 10 shares of Corporation X stock in the exchange. Immediately after the exchange, Corporation X is solvent and A owns 100% of its outstanding stock. Under paragraph (a)(1)(iii) of this section, the 10 shares of Corporation X stock received by A will not be treated as issued for property because the fair market value of the apartment building does not exceed the amount of A’s liabilities assumed by Corporation X. Therefore, section 351 does not apply to the exchange.

(A) The fair market value of the transferred property does not exceed the sum of the amount of liabilities of the transferor that are assumed by the transferee in connection with the transfer and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 351(a) without the recognition of gain) received by the transferor in connection with the transfer. For this purpose, any obligation of the transferor for which the transferee is the obligee that is extinguished for federal income tax purposes in connection with the transfer is treated as a liability assumed by the transferee; or

(ii) Stock will not be treated as issued for property if it is issued for property which is of relatively small value in comparison to the value of the stock already owned (or to be received for services) by the person who transferred such property and the primary purpose of the transfer is to qualify under this section the exchanges of property by other persons transferring property; and

(i) Stock will not be treated as issued for property if it is issued for services rendered or to be rendered to or for the benefit of the issuing corporation;

(a)(1) Section 351(a) provides, in general, for the nonrecognition of gain or loss upon the transfer by one or more persons of property to a corporation solely in exchange for stock of such corporation if, immediately after the exchange, such person or persons are in control of the corporation to which the property was transferred. * * * For purposes of this section, stock rights and stock warrants are not included in the term stock. In addition, for purposes of this section —

§1.368-1 Purpose and scope of exception to reorganization exchanges.

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(b)(1) * * * Requisite to a reorganization under the Internal Revenue Code are a continuity of business enterprise through the issuing corporation under the modified corporate form as described in paragraph (d) of this section, a continuity of interest as described in paragraph (e) of this section (except as provided in section 368(a)(1)(D)), and an exchange of net value as described in paragraph (f) of this section. Notwithstanding the requirements of this paragraph (b)(1), an exchange of net value is not required for a transaction to qualify as a reorganization under section 368(a)(1)(E) or (F) and, to the extent provided in paragraph (f)(4), for a transaction to qualify as a reorganization under section 368(a)(1)(D). * * *

(2) Effective dates. The third and fourth sentences of paragraph (b)(1) of this section apply to transactions occurring after the date these proposed regulations are published as final regulations in the Federal Register. The fifth and sixth sentences apply to transactions occurring after January 28, 1998, except that they do not apply to any transaction occurring pursuant to a written agreement which is binding on January 28, 1998, and at all times thereafter.

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(e) * * *

(1) * * *

(i) * * * See paragraph (e)(6) of this section for rules related to when a creditor’s claim against a target corporation is a proprietary interest in the corporation. * * *

(ii) * * * A proprietary interest in the target corporation is not preserved to the extent that creditors (or former creditors) of the target corporation that own a proprietary interest in the corporation under paragraph (e)(6) of this section (or would be so treated if they had received the consideration in the potential reorganization) receive payment for the claim prior to the potential reorganization.

(2) * * * A proprietary interest in the target corporation is not preserved if, in connection with a potential reorganization, a person related (as defined in paragraph (e)(3) of this section) to the issuing corporation acquires either a proprietary interest in the target corporation or stock of the issuing corporation that was furnished in exchange for a proprietary interest in the target corporation for consideration other than stock of the issuing corporation. The preceding sentence does not apply to the extent those persons who were the direct or indirect owners of the target corporation prior to the potential reorganization maintain a direct or indirect proprietary interest in the issuing corporation.

* * * * *

(6) Creditors’ claims as proprietary interests—(i) In general. A creditor’s claim against a target corporation may be a proprietary interest in the target corporation if the target corporation is in a title 11 or similar case (as defined in section 368(a)(3)) or the amount of the target corporation’s liabilities exceeds the fair market value of its assets immediately prior to the potential reorganization. In such cases, if any creditor receives a proprietary interest in the issuing corporation in exchange for its claim, every claim of that class of creditors and every claim of all equal and junior classes of creditors (in addition to the claims of shareholders) is a proprietary interest in the target corporation immediately prior to the potential reorganization.

(ii) Value of proprietary interest—(A) In general. Generally, if a creditor’s claim is a proprietary interest in the target corporation, the value of the proprietary interest is the fair market value of the creditor’s claim.

(B) Claims of creditors of most senior classes. For a claim of the most senior class of creditors receiving a proprietary interest in the issuing corporation and a claim of any equal class of creditors, the value of the proprietary interest in the target corporation represented by the claim is determined by multiplying the fair market value of the claim by a fraction, the numerator of which is the fair market value of the proprietary interests in the issuing corporation that are received in the aggregate in exchange for the claims of those classes of creditors, and the denominator of which is the sum of the amount of money and the fair market value of all other consideration (including the proprietary interests in the issuing corporation) received in the aggregate in exchange for such claims.

(iii) Bifurcated claims. If a creditor’s claim is bifurcated into a secured claim and an unsecured claim pursuant to an order in a title 11 or similar case (as defined in section 368(a)(3)) or pursuant to an agreement between the creditor and the debtor, the bifurcation of the claim and the allocation of consideration to each of the resulting claims will be respected in applying the rules of this paragraph (e)(6).

(iv) Effect of treating creditors as proprietors. The treatment of a creditor’s claim as a proprietary interest in the target corporation shall not preclude treating shares of the target corporation as proprietary interests in the target corporation.

(7) * * *

* * * * *

Example 10. Creditors treated as owning a proprietary interest. T has assets with a fair market value of $150x and liabilities of $200x. T has two classes of creditors, the senior creditors with claims of $50x, and the junior creditors with claims of $150x. T transfers all of its assets to P in exchange for $95x and shares of P stock with a fair market value of $55x. The T senior creditors receive in the aggregate $40x and P stock with a fair market value of $10x in exchange for their claims. Each T senior creditor receives stock and nonstock consideration in the same proportion. The T junior creditors receive $55x and P stock with a fair market value of $45x in exchange for their claims. The T shareholders receive no consideration in exchange for their T stock. Under paragraph (e)(6) of this section, because the amount of T’s liabilities exceeds the fair market value of its assets immediately prior to the potential reorganization, the claims of the creditors of T may be proprietary interests in T. Because the senior creditors receive proprietary interests in P in the transaction in exchange for their claims, their claims and the claims of the junior creditors and the T shareholders are treated as proprietary interests in T immediately prior to the transaction. Under paragraph (e)(6)(ii) of this section, the value of the senior creditors’ proprietary interests in T is $10x, the value of the proprietary interests in P that they received in exchange for their claims. In addition, the value of the junior creditors’ proprietary interests in T immediately prior to the transaction is $100x, the value of their claims. Because P is treated as acquiring 50 percent of the value of the proprietary interests in T in exchange for P stock ($55x/$110x), a substantial part of the value of the proprietary interests in T is preserved. Therefore, the continuity of interest requirement is satisfied.

(8) * * * The sixth sentence of paragraph (e)(1)(i) of this section, the last sentence of paragraph (e)(1)(ii) of this section, paragraph (e)(2) of this section, paragraph (e)(6) of this section, and Example 10 of paragraph (e)(7) of this section apply to transactions occurring after the date these proposed regulations are published as final regulations in the Federal Register.

(f) Exchanges of net value—(1) General rule. An exchange of net value requires that there be both a surrender of net value and a receipt of net value. Whether there is a surrender of net value is determined by reference to the assets and liabilities of the target corporation. Whether there is a receipt of net value is determined by reference to the assets and liabilities of the issuing corporation (as defined in paragraph (b) of this section). The purpose of the exchange of net value requirement is to prevent transactions that resemble sales (including transfers of assets in satisfaction of liabilities) from qualifying for nonrecognition of gain or loss available to corporate reorganizations.

(2) Asset transactions. There is an exchange of net value in a potential reorganization to which section 361 would apply only if —

(i) Surrender of net value. The fair market value of the property transferred by the target corporation to the acquiring corporation exceeds the sum of the amount of liabilities of the target corporation that are assumed by the acquiring corporation in connection with the exchange and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 361(a) without the recognition of gain) received by the target corporation in connection with the exchange. For this purpose, any obligation of the target corporation for which the acquiring corporation is the obligee that is extinguished for federal income tax purposes in connection with the exchange is treated as a liability assumed by the acquiring corporation; and

(ii) Receipt of net value. The fair market value of the assets of the issuing corporation exceeds the amount of its liabilities immediately after the exchange.

(3) Stock transactions. There is an exchange of net value in a potential reorganization under section 368(a)(1)(B) or section 368(a)(1)(A) by reason of section 368(a)(2)(E) only if —

(i) Surrender of net value. The fair market value of the assets of the target corporation exceeds the sum of the amount of the liabilities of the target corporation immediately prior to the exchange and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 354 without the recognition of gain and nonqualified preferred stock within the meaning of section 351(g)) received by the shareholders of the target corporation in connection with the exchange. For this purpose, assets of the target corporation that are not held immediately after the exchange and liabilities of the target corporation that are extinguished for federal income tax purposes in the exchange other than ones, if any, to the corporation into which the target corporation merges in the case of a potential reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(E) are disregarded; and

(ii) Receipt of net value. The fair market value of the assets of the issuing corporation exceeds the amount of its liabilities immediately after the exchange.

(4) Exception. The requirement that there be an exchange of net value does not apply to a transaction that would otherwise qualify as a reorganization under section 368(a)(1)(D) by reason of section 354 or so much of section 356 as relates to section 354, provided that the fair market value of the property transferred to the acquiring corporation by the target corporation exceeds the amount of liabilities of the target corporation immediately before the exchange (including any liabilities cancelled, extinguished, or assumed in connection with the exchange), and the fair market value of the assets of the acquiring corporation equals or exceeds the amount of its liabilities immediately after the exchange.

(5) Examples. For purposes of the examples in this paragraph (f)(5), each of P, S, and T is a corporation; all corporations have only one class of stock outstanding; A, B, C, and D are individuals; and the transaction is not otherwise subject to recharacterization. Except as otherwise provided, no person is related to any other person and the fair market value of the assets of each corporation exceeds the amount of its liabilities immediately prior to the transaction described in the example. The following examples illustrate the application of this paragraph (f).

Example 1. T has assets with a fair market value of $50x and liabilities of $75x, all of which are owed to A. T transfers all of its assets to S in exchange for S stock with a fair market value of $50x. T distributes the S stock to A in exchange for the T debt owed to A. T dissolves. T’s shareholders receive nothing in exchange for their T stock. Under paragraph (f)(2)(i) of this section, T surrenders net value because the fair market value of the property transferred by T ($50x) exceeds the sum of the amount of liabilities that are assumed by S in connection with the exchange ($0x) and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 361(a) without the recognition of gain) received by T in connection with the exchange ($0x). In addition, under paragraph (f)(2)(ii) of this section, T receives net value because the fair market value of the assets of S exceeds the amount of its liabilities immediately after the exchange. Therefore, under paragraph (f) of this section, there is an exchange of net value.

Example 2. P owns all of the stock of both S and T. T has assets with a fair market value of $100x and liabilities of $160x, all of which are owed to P. T transfers all of its assets to S in exchange for S stock with a fair market value of $100x. T distributes the S stock to P in exchange for the T debt owed to P. T dissolves. P receives nothing in exchange for its T stock. Under paragraph (f)(2)(i) of this section, T surrenders net value because the fair market value of the property transferred by T ($100x) exceeds the sum of the amount of liabilities of T assumed by S in connection with the exchange ($0x) and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 361(a) without the recognition of gain) received by T in connection with the exchange ($0x). In addition, under paragraph (f)(2)(ii) of this section, T receives net value because the fair market value of the assets of S exceeds the amount of its liabilities immediately after the exchange. Therefore, under paragraph (f) of this section, there is an exchange of net value. The result would be the same if no S stock were issued.

Example 3. The facts are the same as in Example 2, except that T’s debt is owed to B. T transfers all of its assets to S in exchange for the assumption of T’s liabilities. T dissolves. The obligation to B is outstanding immediately after the transfer. P receives nothing in exchange for its T stock. Under paragraph (f)(2)(i) of this section, T does not surrender net value because the fair market value of the property transferred by T ($100x) does not exceed the sum of the amount of liabilities of T assumed by S in connection with the exchange ($160x). Therefore, under paragraph (f) of this section, there is no exchange of net value. The result would be the same if S stock were issued.

Example 4. The facts are the same as in Example 3, except that S first assumes the T debt owed to B and subsequently T transfers all of its assets to S in exchange for S stock with a fair market value of $100x. If S’s assumption of the T debt is made in connection with the subsequent transfer of T assets to S, under paragraph (f)(2)(i) of this section, T does not surrender net value because the fair market value of the property transferred by T ($100x) does not exceed the sum of the amount of liabilities of T assumed by S in connection with the exchange ($160x). Therefore, under paragraph (f) of this section, there is no exchange of net value.

Example 5. P owns 70% of the stock of T. A owns the remaining 30% of the stock of T. T has assets with a fair market value of $100x and liabilities of $160x, all of which are owed to P. T merges into P. A receives nothing in exchange for its T stock. Under (f)(2)(i) of this section, even though T’s obligation to P is extinguished in the transaction, it is treated as a liability assumed by P. Thus, under paragraph (f)(2)(i) of this section, T does not surrender net value because the fair market value of the property transferred by T ($100x) does not exceed the sum of the amount of liabilities of T assumed by P in connection with the exchange ($160x). Therefore, under paragraph (f) of this section, there is no exchange of net value.

Example 6. A owns all of the stock of S. S has assets with a fair market value of $200x and liabilities of $500x, all of which are owed to T. The S debt has a fair market value of $200x. In addition to the S debt, T has other assets that have a fair market value of $700x. T has no liabilities. T transfers all of its assets to S in exchange for S stock with a fair market value of $900x. T distributes the S stock to its shareholders in exchange for their T stock. T dissolves. S cancels all of its stock held by its shareholders immediately prior to the exchange. Under paragraph (f)(2)(i) of this section, T surrenders net value because the fair market value of the property transferred by T ($900x) exceeds the sum of the amount of liabilities of T assumed by S in connection with the exchange ($0x) and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 361(a) without the recognition of gain) received by T in connection with the exchange ($0x). In addition, under paragraph (f)(2)(ii) of this section, T receives net value because the fair market value of the assets of S ($900x) exceeds the amount of the liabilities of S ($0x) immediately after the exchange. Therefore, under paragraph (f) of this section, there is an exchange of net value.

Example 7. P owns all of the stock of S. T has assets with a fair market value of $300x and liabilities of $650x, $500x of which are owed to P and $150x of which are owed to A. T merges into S. In the merger, P stock is issued to A in satisfaction of the debt owed to A by T. Also in the merger, P contributes to the capital of T the debt P is owed. Assume the merger would qualify as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(D) if the exchange of net value requirement in paragraph (f)(1) of this section did not apply. Whether there is a surrender of net value is determined by reference to the actual merger of T into S. Thus, T surrenders net value because the fair market value of the property transferred by T ($300x) exceeds the sum of the amount of liabilities of T assumed by S in connection with the exchange ($0x) and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 361(a) without the recognition of gain) received by T in connection with the exchange ($0x). Whether there is a receipt of net value is determined by reference to the issuing corporation, in this case, P. T receives net value because the fair market value of the assets of P exceeds the amount of the liabilities of P immediately after the exchange. Therefore, under paragraph (f) of this section, there is an exchange of net value.

Example 8. P owns all of the stock of both S and T. T transfers all of its assets to S in exchange for $34x, the assets’ fair market value. Following this transfer, T pays its debts of $2x and dissolves, distributing the remaining $32x to P. Assume the transaction would qualify as a reorganization under section 368(a)(1)(D) by reason of section 354 or so much of section 356 as relates to section 354 if the net value requirement in paragraph (f)(1) of this section did not apply. Under paragraph (f)(2) of this section, there is no exchange of net value because the fair market value of the property transferred by T ($34x) does not exceed the amount of money received by T in connection with the exchange ($34x). However, under paragraph (f)(4) of this section, because the transaction would otherwise qualify as a reorganization under section 368(a)(1)(D) and the other requirements of paragraph (f)(4) of this section are satisfied, the exchange of net value requirement does not apply. Accordingly, the transaction qualifies as a reorganization under section 368(a)(1)(D).

Example 9. A and B own all of the stock of T. T has assets with a fair market value of $500x and liabilities of $900x, all of which are owed to C and D, security holders of T. P acquires all of the stock and securities of T in exchange for P voting stock. In the transaction, A and B receive nothing in exchange for their stock of T. C and D exchange all of their securities of T for stock of P. Under paragraph (f)(3)(i) of this section, there is a surrender of net value because the fair market value of the assets of T held immediately prior to the exchange that are held immediately after the exchange ($500x) exceeds the sum of the amount of liabilities of T immediately prior to the exchange ($0x, disregarding the liabilities of $900x extinguished in the exchange) and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 354 without the recognition of gain and nonqualified preferred stock within the meaning of section 351(g)) received by the shareholders of T ($0x). In addition, under paragraph (f)(3)(ii) of this section, there is a receipt of net value because the fair market value of the assets of P exceeds the amount of the liabilities of P immediately after the exchange. Therefore, under paragraph (f) of this section, there is an exchange of net value.

Example 10. A and B own all of the stock of P, and C and D own all of the stock of T. P has assets with a fair market value of $400x and liabilities of $500x, and T has assets with a fair market value of $1000x and liabilities of $600x. P acquires all of the stock of T. C and D exchange all of their T stock, with a fair market value of $400x, for P stock with a fair market value of $300x immediately after the transaction. P cancels all of the stock held by A and B immediately prior to the exchange. Under paragraph (f)(3)(i) of this section, there is a surrender of net value because the fair market value of the assets of T held immediately prior to the exchange that are held immediately after the exchange ($1000x) exceeds the amount of liabilities of T ($600x) immediately prior to the exchange and the amount of any money and the fair market value of any other property (other than stock permitted to be received under section 354 without the recognition of gain and nonqualified preferred stock within the meaning of section 351(g)) received by the shareholders of T ($0x). In addition, under paragraph (f)(3)(ii) of this section, there is a receipt of net value because the fair market value of the assets of P ($800x), which includes the fair market value of the stock of T, exceeds the amount of its liabilities ($500x) immediately after the exchange. Therefore, under paragraph (f) of this section, there is an exchange of net value. To the extent that C and D surrender T stock with a value in excess of the value of the P stock they receive, the tax consequences of the surrender of the additional stock are determined based on the facts and circumstances.

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

Par. 5. Section 1.368-2 is amended by revising paragraph (d)(1) to read as follows: