IRS Proposes Basis-Tracing Regulations

The IRS has issued proposed regulations that propose a comprehensive approach for stock basis recovery.

The regulations, if adopted as final, would apply across a broad spectrum of transactions. They will create a single model for stock basis recovery if a shareholder receives a dividend under IRC § 301. These transactions are labeled “dividend-equivalent transactions.” Another model would apply to sale and exchange transactions under section 302(a). These transactions are labeled “non-dividend-equivalent transactions.”

The proposed regulations, which add or revise 11 sections in all, would treat a distribution under IRC § 301 as received by a shareholder on a pro rata, share-by-share basis. A surprising effect of the new basis-tracing system of Prop. Treas. Reg. § 1.301-2 is that a distribution under section 301(c)(1) (a distribution in excess of earnings and profits and of basis) could result in a gain for a portion of the shares in a class and unrecovered basis in other shares in that same class.

Dividend-equivalent redemptions would be treated in much the same way. Such redemptions would result in the same pro rata, share-by-share reduction of a shareholder’s stock held immediately before the redemption. Again, this determination could result in a gain from some shares while other shares of the same class could have unrecovered basis.

Reorganization treatment will depend upon whether the reorganization exchange is dividend-equivalent or not. To determine whether the transaction is dividend-equivalent, the overall exchange must be taken into account. Thus, an exchange of one class of stock solely for “boot” and another class of stock solely for nonqualifying property must be considered as a whole. (Boot is money or any other property that doesn’t qualify for nonrecognition of gain in an otherwise nontaxable exchange.)

If the reorganization is treated as dividend-equivalent because different classes of stock are distinct and have specific legal rights, the exchange of a class of stock solely for boot would be an exchange to which section 302(d) applies, and the reorganization provisions of section 356(a)(2) would not apply. If it is determined that the reorganization is not dividend-equivalent, section 302(a) would still require the recognition of gain to the extent that boot is received.

The proposed regulations also address capital contributions. Under Prop. Treas. Reg. § 1.1016-2, capital contributions are treated as being made in exchange for shares followed by a recapitalization into the remaining shares. The principles of Prop. Treas. Reg. § 1.358-2(g)(3) (allocation of basis in a section 351 transaction in which stock is deemed received) apply.

The proposed regulations represent an attempt to develop a comprehensive system for capital contributions to and distributions from a corporation. However, as proposed, the identification of the basis for each individual share may require an excessive amount of recordkeeping to achieve the benefits of a comprehensive system.

 REG-143686-07, IRB 2009-8, The Allocation of Consideration and Allocation and Recovery of Basis in Transactions Involving Corporate Stock or Securities

By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.