[Code of Federal Regulations]
[Title 26, Volume 12]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1502-32]

[Page 379-395]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1502-32  Investment adjustments.

    (a) In general--(1) Purpose. This section provides rules for 
adjusting the basis of the stock of a subsidiary (S) owned by another 
member (P). These rules modify the determination of P's basis in S's 
stock under applicable rules of law by adjusting P's basis to reflect 
S's distributions and S's items of income, gain, deduction, and loss 
taken into account for the period that S is a member of the consolidated

[[Page 380]]

group. The purpose of the adjustments is to treat P and S as a single 
entity so that consolidated taxable income reflects the group's income. 
For example, if P forms S with a $100 contribution, and S takes into 
account $10 of income, P's $100 basis in S's stock under section 358 is 
increased by $10 under this section to prevent S's income from being 
taken into account a second time on P's disposition of S's stock. 
Comparable adjustments are made for tax-exempt income and noncapital, 
nondeductible expenses that S takes into account, to preserve their 
treatment under the Internal Revenue Code.
    (2) [Reserved]. For further guidance, see Sec. 1.1502-32T(a)(2).
    (3) Overview--(i) In general. The amount of the stock basis 
adjustments and their timing are determined under paragraph (b) of this 
section. Under paragraph (c) of this section, the amount of the 
adjustment is allocated among the shares of S's stock. Paragraphs (d) 
through (g) of this section provide definitions, an anti-avoidance rule, 
successor rules, and recordkeeping requirements.
    (ii) Excess loss account. Negative adjustments under this section 
may exceed P's basis in S's stock. The resulting negative amount is P's 
excess loss account in S's stock. See Sec. 1.1502-19 for rules treating 
excess loss accounts as negative basis, and treating references to stock 
basis as including references to excess loss accounts.
    (iii) Tiering up of adjustments. The adjustments to S's stock under 
this section are taken into account in determining adjustments to 
higher-tier stock. The adjustments are applied in the order of the 
tiers, from the lowest to the highest. For example, if P is also a 
subsidiary, P's adjustment to S's stock is taken into account in 
determining the adjustments to stock of P owned by other members.
    (b) Stock basis adjustments--(1) Timing of adjustments--(i) In 
general. Adjustments under this section are made as of the close of each 
consolidated return year, and as of any other time (an interim 
adjustment) if a determination at that time is necessary to determine a 
tax liability of any person. For example, adjustments are made as of P's 
sale of S's stock in order to measure P's gain or loss from the sale, 
and if P's interest in S's stock is not uniform throughout the year 
(e.g., because P disposes of a portion of its S stock, or S issues 
additional shares to another person), the adjustments under this section 
are made by taking into account the varying interests. An interim 
adjustment may be necessary even if tax liability is not affected until 
a later time. For example, if P sells only 50% of S's stock and S 
becomes a nonmember, adjustments must be made for the retained stock as 
of the disposition (whether or not P has an excess loss account in that 
stock). Similarly, if S liquidates during a consolidated return year, 
adjustments must be made as of the liquidation (even if the liquidation 
is tax free under section 332).
    (ii) Allocation of items. If Sec. 1.1502-76(b) applies to S for 
purposes of an adjustment before the close of the group's consolidated 
return year, the amount of the adjustment is determined under that 
section. If Sec. 1.1502-76(b) does not apply to the interim adjustment, 
the adjustment is determined under the principles of Sec. 1.1502-76(b), 
consistently applied, and ratable allocation under the principles of 
Sec. 1.1502-76(b)(2)(ii) or (iii) may be used without filing an 
election under Sec. 1.1502-76(b)(2). The principles would apply, for 
example, if P becomes a nonmember but S remains a member.
    (2) Amount of adjustments. P's basis in S's stock is increased by 
positive adjustments and decreased by negative adjustments under this 
paragraph (b)(2). The amount of the adjustment, determined as of the 
time of the adjustment, is the net amount of S's--
    (i) Taxable income or loss;
    (ii) Tax-exempt income;
    (iii) Noncapital, nondeductible expenses; and
    (iv) Distributions with respect to S's stock.
    (3) Operating rules. For purposes of determining P's adjustments to 
the basis of S's stock under paragraph (b)(2) of this section--
    (i) Taxable income or loss. S's taxable income or loss is 
consolidated taxable income (or loss) determined by including only S's 
items of income, gain, deduction, and loss taken into account in

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determining consolidated taxable income (or loss), treating S's 
deductions and losses as taken into account to the extent they are 
absorbed by S or any other member. For this purpose:
    (A) To the extent that S's deduction or loss is absorbed in the year 
it arises or is carried forward and absorbed in a subsequent year (e.g., 
under section 172, 465, or 1212), the deduction or loss is taken into 
account under paragraph (b)(2) of this section in the year in which it 
is absorbed.
    (B) To the extent that S's deduction or loss is carried back and 
absorbed in a prior year (whether consolidated or separate), the 
deduction or loss is taken into account under paragraph (b)(2) of this 
section in the year in which it arises and not in the year in which it 
is absorbed.
    (ii) Tax-exempt income--(A) In general. S's tax-exempt income is its 
income and gain which is taken into account but permanently excluded 
from its gross income under applicable law, and which increases, 
directly or indirectly, the basis of its assets (or an equivalent 
amount). For example, S's dividend income to which Sec. 1.1502-
13(f)(2)(ii) applies, and its interest excluded from gross income under 
section 103, are treated as tax-exempt income. However, S's income not 
recognized under section 1031 is not treated as tax- exempt income 
because the corresponding basis adjustments under section 1031(d) 
prevent S's nonrecognition from being permanent. Similarly, S's tax-
exempt income does not include gain not recognized under section 332 
from the liquidation of a lower-tier subsidiary, or not recognized under 
section 118 or section 351 from a transfer of assets to S.
    (B) Equivalent deductions. To the extent that S's taxable income or 
gain is permanently offset by a deduction or loss that does not reduce, 
directly or indirectly, the basis of S's assets (or an equivalent 
amount), the income or gain is treated as tax-exempt income and is taken 
into account under paragraph (b)(3)(ii)(A) of this section. In addition, 
the income and the offsetting item are taken into account under 
paragraph (b)(3)(i) of this section. For example, if S receives a $100 
dividend with respect to which a $70 dividends received deduction is 
allowed under section 243, $70 of the dividend is treated as tax-exempt 
income. Accordingly, P's basis in S's stock increases by $100 because 
the $100 dividend and $70 deduction are taken into account under 
paragraph (b)(3)(i) of this section (resulting in $30 of the increase), 
and $70 of the dividend is also taken into account under paragraph 
(b)(3)(ii)(A) of this section as tax-exempt income (resulting in $70 of 
the increase). (See paragraph (b)(3)(iii) of this section if there is a 
corresponding negative adjustment under section 1059.) Similarly, income 
from mineral properties is treated as tax-exempt income to the extent it 
is offset by deductions for depletion in excess of the basis of the 
property.
    (C) Discharge of indebtedness income--(1) [Reserved]. For further 
guidance, see Sec. 1.1502-32T(b)(3)(ii)(C)(1).
    (2) Expired loss carryovers. If the amount of the discharge exceeds 
the amount of the attribute reduction, the excess is nevertheless 
treated as applied to reduce tax attributes to the extent a loss 
carryover expired without tax benefit, the expiration was taken into 
account as a noncapital, nondeductible expense under paragraph 
(b)(3)(iii) of this section, and the loss carryover would have been 
reduced had it not expired.
    (D) Basis shifts. An increase in the basis of S's assets (or an 
equivalent as described in paragraph (b)(3)(iv)(B) of this section) is 
treated as tax-exempt income to the extent that the increase is not 
otherwise taken into account in determining stock basis, it corresponds 
to a negative adjustment that is taken into account by the group under 
this paragraph (b) (or incurred by the common parent), and it has the 
effect (viewing the group in the aggregate) of a permanent recovery of 
the reduction. For example, S's basis increase under section 50(c)(2) is 
treated as tax-exempt income to the extent the preceding basis reduction 
under section 50(c)(1) is reflected in the basis of a member's stock. On 
the other hand, if S increases the basis of an asset as the result of an 
accounting method change, and the related positive section 481(a) 
adjustment is taken into account over time, the basis increase is not 
treated as tax-exempt income.

[[Page 382]]

    (iii) Noncapital, nondeductible expenses--(A) [Reserved]. For 
further guidance, see Sec. 1.1502-32T(b)(3)(iii)(A).
    (B) Nondeductible basis recovery. Any other decrease in the basis of 
S's assets (or an equivalent as described in paragraph (b)(3)(iv)(B) of 
this section) may be a noncapital, nondeductible expense to the extent 
that the decrease is not otherwise taken into account in determining 
stock basis and is permanently eliminated for purposes of determining 
S's taxable income or loss. Whether a decrease is so treated is 
determined by taking into account both the purposes of the Code or 
regulatory provision resulting in the decrease and the purposes of this 
section. For example, S's noncapital, nondeductible expenses include any 
basis reduction under section 50(c)(1), section 1017, section 1059, 
Sec. 1.1502-35T(b) or (f)(2). Also included as a noncapital, 
nondeductible expense is the amount of any gross-up for taxes paid by 
another taxpayer that S is treated as having paid (e.g., income included 
under section 78, or the portion of an undistributed capital gain 
dividend that is treated as tax deemed to have been paid by a 
shareholder under section 852(b)(3)(D)(ii), whether or not any 
corresponding amount is claimed as a tax credit). In contrast, a 
decrease generally is not a noncapital, nondeductible expense if it 
results because S redeems stock in a transaction to which section 302(a) 
applies, S receives assets in a liquidation to which section 332 applies 
and its basis in the assets is less than its basis in the stock 
canceled, or S distributes the stock of a subsidiary in a distribution 
to which section 355 applies.
    (C) and (D) [Reserved]. For further guidance, see Sec. 1.1502-
32T(b)(3)(iii)(C) and (D).
    (iv) Special rules for tax-exempt income and noncapital, 
nondeductible expenses. For purposes of paragraphs (b)(3)(ii) and (iii) 
of this section:
    (A) Treatment as permanent. An amount is permanently excluded from 
gross income, or permanently disallowed or eliminated, if it is so 
treated by S even though another person may take a corresponding amount 
into account. For example, if S sells property to a nonmember at a loss 
that is disallowed under section 267(a), S's loss is a noncapital, 
nondeductible expense even though under section 267(d) the nonmember may 
treat a corresponding amount of gain as not recognized. (If the 
nonmember is a subsidiary in another consolidated group, its gain not 
recognized under section 267(d) is tax-exempt income under paragraph 
(b)(3)(ii)(A) of this section.)
    (B) Amounts equivalent to basis and adjustments to basis. Amounts 
equivalent to basis include the amount of money, the amount of a loss 
carryover, and the amount of an adjustment to gain or loss under section 
475(a) for securities described in section 475(a)(2). An equivalent to a 
basis increase includes a decrease in an excess loss account, and an 
equivalent to a basis decrease includes the denial of basis for taxable 
income.
    (C) Timing. An amount is taken into account in the year in which it 
would be taken into account under paragraph (b)(3)(i) of this section if 
it were subject to Federal income taxation.
    (D) Tax sharing agreements. Taxes are taken into account by applying 
the principles of section 1552 and the percentage method under Sec. 
1.1502-33(d)(3) (and by assuming a 100% allocation of any decreased tax 
liability). The treatment of amounts allocated under this paragraph 
(b)(3)(iv)(D) is analogous to the treatment of allocations under Sec. 
1.1552-1(b)(2). For example, if one member owes a payment to a second 
member, the first member is treated as indebted to the second member. 
The right to receive payment is treated as a positive adjustment under 
paragraph (b)(3)(ii) of this section, and the obligation to make payment 
is treated as a negative adjustment under paragraph (b)(3)(iii) of this 
section. If the obligation is not paid, the amount not paid generally is 
treated as a distribution, contribution, or both, depending on the 
relationship between the members.
    (v) Distributions. Distributions taken into account under paragraph 
(b)(2) of this section are distributions with respect to S's stock to 
which section 301 applies and all other distributions treated as 
dividends (e.g., under section 356(a)(2)). See Sec. 1.1502-13(f)(2)(iv) 
for taking into account distributions to which section 301 applies (but 
not other distributions treated as dividends) under the entitlement 
rule.

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    (4) Waiver of loss carryovers from separate return limitation 
years--(i) General rule. If S has a loss carryover from a separate 
return limitation year when it becomes a member of a consolidated group, 
the group may make an irrevocable election to treat all or any portion 
of the loss carryover as expiring for all Federal income tax purposes 
immediately before S becomes a member of the consolidated group (deemed 
expiration). If S was a member of another group immediately before it 
became a member of the consolidated group, the expiration is also 
treated as occurring immediately after it ceases to be a member of the 
prior group.
    (ii) Stock basis adjustments from a waiver--(A) Qualifying 
transactions. If S becomes a member of the consolidated group in a 
qualifying cost basis transaction and an election under this paragraph 
(b)(4) is made, the noncapital, nondeductible expense resulting from the 
deemed expiration does not result in a corresponding stock basis 
adjustment for any member under this section. A qualifying cost basis 
transaction is the purchase (i.e., a transaction in which basis is 
determined under section 1012) by members of the acquiring consolidated 
group (while they are members) in a 12-month period of an amount of S's 
stock satisfying the requirements of section 1504(a)(2).
    (B) Nonqualifying transactions. If S becomes a member of the 
consolidated group other than in a qualifying cost basis transaction and 
an election under this paragraph (b)(4) is made, the basis of its stock 
that is owned by members immediately after it becomes a member is 
subject to reduction under the principles of this section to reflect the 
deemed expiration. The reduction occurs immediately before S becomes a 
member, but after it ceases to be a member of any prior group, and it 
therefore does not result in a corresponding stock basis adjustment for 
any higher-tier member of the transferring or acquiring consolidated 
group. Any basis reduction under this paragraph (b)(4)(ii)(B) is taken 
into account in making determinations of basis under the Code with 
respect to S's stock (e.g., a determination under section 362 because 
the stock is acquired in a transaction described in section 
368(a)(1)(B)), but it does not result in corresponding stock basis 
adjustments under this section for any higher-tier member. If the basis 
reduction exceeds the basis of S's stock, the excess is treated as an 
excess loss account to which the members owning S's stock succeed.
    (C) Higher-tier corporations. If S becomes a member of the 
consolidated group as a result, in whole or in part, of a higher-tier 
corporation becoming a member (whether or not in a qualifying cost basis 
transaction), additional adjustments are required. The highest-tier 
corporation (T) whose becoming a member resulted in S becoming a member, 
and T's chain of lower-tier corporations that includes S, are subject to 
the adjustment. The deemed expiration of S's loss carryover that results 
in a negative adjustment for the first higher-tier corporation is 
treated as an expiring loss carryover of that higher-tier corporation 
for purposes of applying paragraph (b)(4)(ii)(B) of this section to that 
corporation. For example, if P purchases all of the stock of T, T owns 
all of the stock of T1, T1 owns all of the stock of S, S becomes a 
member as a result of T becoming a member, and the election under this 
paragraph (b)(4) is made, the basis of the S stock is reduced and the 
reduction tiers up to T1, T1 treats the negative adjustment to its basis 
in S's stock as an expiring loss carryover of T1, and T then adjusts its 
basis in T1's stock. In addition, if T becomes a member of the acquiring 
group in a transaction other than a qualifying cost basis transaction, 
the amount that tiers up to T also reduces the basis of its stock under 
paragraph (b)(4)(ii)(B) of this section (but the amount does not tier up 
to higher-tier members).
    (iii) Net asset basis limitation. Basis reduced under this paragraph 
(b)(4) is restored before S becomes a member (and before the basis of 
S's stock is taken into account in determining basis under the Code) to 
the extent necessary to conform a share's basis to its allocable portion 
of net asset basis. In the case of higher-tier corporations under 
paragraph (b)(4)(ii)(C) of this section, the restoration does not tier 
up but is instead applied separately to

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each higher-tier corporation. For purposes of determining each 
corporation's net asset basis (including the basis of stock in lower-
tier corporations), the restoration is applied in the order of tiers, 
from the lowest to the highest. For purposes of the restoration:
    (A) A member's net asset basis is the positive or negative 
difference between the adjusted basis of its assets (and the amount of 
any of its loss carryovers that are not deemed to expire) and its 
liabilities. Appropriate adjustments must be made, for example, to 
disregard liabilities that subsequently will give rise to deductions 
(e.g., liabilities to which section 461(h) applies).
    (B) Within a class of stock, each share has the same allocable 
portion of net asset basis. If there is more than one class of common 
stock, the net asset basis is allocated to each class by taking into 
account the terms of each class and all other facts and circumstances 
relating to the overall economic arrangement.
    (iv) Election. The election described in this paragraph (b)(4) must 
be made in a separate statement entitled ``ELECTION TO TREAT LOSS 
CARRYOVER AS EXPIRING UNDER Sec. 1.1502-32(b)(4).'' The statement must 
be filed with the consolidated group's return for the year S becomes a 
member, and it must be signed by the common parent and S. A separate 
statement must be made for each member whose loss carryover is deemed to 
expire. The statement must identify the amount of each loss carryover 
deemed to expire (or the amount of each loss carryover deemed not to 
expire, with any balance of any loss carryovers being deemed to expire), 
the basis of any stock reduced as a result of the deemed expiration, and 
the computation of the basis reduction.
    (v) [Reserved]. For further guidance, see Sec. 1.1502-32T(b)(4)(v).
    (vi) [Reserved]. For further guidance, see Sec. 1.1502-
32T(b)(4)(vi).
    (vii) [Reserved]. For further guidance, see Sec. 1.1502-
32T(b)(4)(vii).
    (5) Examples--(i) In general. For purposes of the examples in this 
section, unless otherwise stated, P owns all of the only class of S's 
stock, the stock is owned for the entire year, S owns no stock of lower-
tier members, the tax year of all persons is the calendar year, all 
persons use the accrual method of accounting, the facts set forth the 
only corporate activity, preferred stock is described in section 
1504(a)(4), all transactions are between unrelated persons, and tax 
liabilities are disregarded.
    (ii) Stock basis adjustments. The principles of this paragraph (b) 
are illustrated by the following examples.

    Example 1. Taxable income. (a) Current taxable income. For Year 1, 
the P group has $100 of taxable income when determined by including only 
S's items of income, gain, deduction, and loss taken into account. Under 
paragraph (b)(1) of this section, P's basis in S's stock is adjusted 
under this section as of the close of Year 1. Under paragraph (b)(2) of 
this section, P's basis in S's stock is increased by the amount of the P 
group's taxable income determined by including only S's items taken into 
account. Thus, P's basis in S's stock is increased by $100 as of the 
close of Year 1.
    (b) Intercompany gain that is not taken into account. The facts are 
the same as in paragraph (a) of this Example 1, except that S also sells 
property to another member at a $25 gain in Year 1, the gain is deferred 
under Sec. 1.1502-13 and taken into account in Year 3, and P sells 10% 
of S's stock to nonmembers in Year 2. Under paragraph (b)(3)(i) of this 
section, S's deferred gain is not additional taxable income for Year 1 
or 2 because it is not taken into account in determining the P group's 
consolidated taxable income for either of those years. The deferred gain 
is not tax-exempt income under paragraph (b)(3)(ii) of this section 
because it is not permanently excluded from S's gross income. The 
deferred gain does not result in a basis adjustment until Year 3, when 
it is taken into account in determining the P group's consolidated 
taxable income. Consequently, P's basis in the S shares sold is not 
increased to reflect S's gain from the intercompany sale of the 
property. In Year 3, the deferred gain is taken into account, but the 
amount allocable to the shares sold by P does not increase their basis 
because these shares are held by nonmembers.
    (c) Intercompany gain taken into account. The facts are the same as 
in paragraph (b) of this Example 1, except that P sells all of S's stock 
in Year 2 (rather than only 10%). Under Sec. 1.1502-13, S takes the $25 
gain into account immediately before S becomes a nonmember. Thus, P's 
basis in S's stock is increased to reflect S's gain from the 
intercompany sale of the property.
    Example 2. Tax loss. (a) Current absorption. For Year 2, the P group 
has a $50 consolidated net operating loss when determined by

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taking into account only S's items of income, gain, deduction, and loss. 
S's loss is absorbed by the P group in Year 2, offsetting P's income for 
that year. Under paragraph (b)(3)(i)(A) of this section, because S's 
loss is absorbed in the year it arises, P has a $50 negative adjustment 
with respect to S's stock. Under paragraph (b)(2) of this section, P 
reduces its basis in S's stock by $50. Under paragraph (a)(3)(ii) of 
this section, if the decrease exceeds P's basis in S's stock, the excess 
is P's excess loss account in S's stock.
    (b) Interim determination from stock sale. The facts are the same as 
in paragraph (a) of this Example 2, except that S's Year 2 loss arises 
in the first half of the calendar year, P sells 50% of S's stock on July 
1 of Year 2, and P's income for Year 2 does not arise until after the 
sale of S's stock. P's income for Year 2 (exclusive of the sale of S's 
stock) is offset by S's loss, even though the income arises after the 
stock sale, and no loss remains to be apportioned to S. See Sec. Sec. 
1.1502-11 and 1.1502-21(b). Under paragraph (b)(3)(i)(A) of this 
section, because S's $50 loss is absorbed in the year it arises, it 
reduces P's basis in the S shares sold by $25 immediately before the 
stock sale. Because S becomes a nonmember, the loss also reduces P's 
basis in the retained S shares by $25 immediately before S becomes a 
nonmember.
    (c) Loss carryback. The facts are the same as in paragraph (a) of 
this Example 2, except that P has no income or loss for Year 2, S's $50 
loss is carried back and absorbed by the P group in Year 1 (offsetting 
the income of P or S), and the P group receives a $17 tax refund in Year 
2 that is paid to S. Under paragraph (b)(3)(i)(B) of this section, 
because the $50 loss is carried back and absorbed in Year 1, it is 
treated as a tax loss for Year 2 (the year in which it arises). Under 
paragraph (b)(3)(ii) of this section, the refund is treated as tax-
exempt income of S. Under paragraph (b)(3)(iv)(C) of this section, the 
tax- exempt income is taken into account in Year 2 because that is the 
year it would be taken into account under S's method of accounting if it 
were subject to Federal income taxation. Thus, under paragraph (b)(2) of 
this section, P reduces its basis in S's stock by $33 as of the close of 
Year 2 (the $50 tax loss, less the $17 tax refund).
    (d) Loss carryforward. The facts are the same as in paragraph (a) of 
this Example 2, except that P has no income or loss for Year 2, and S's 
loss is carried forward and absorbed by the P group in Year 3 
(offsetting the income of P or S). Under paragraph (b)(3)(i)(A) of this 
section, the loss is not treated as a tax loss under paragraph (b)(2) of 
this section until Year 3.
    Example 3. Tax-exempt income and noncapital, nondeductible expenses. 
(a) Facts. For Year 1, the P group has $500 of consolidated taxable 
income. However, the P group has a $100 consolidated net operating loss 
when determined by including only S's items of income, gain, deduction, 
and loss taken into account. Also for Year 1, S has $80 of interest 
income that is permanently excluded from gross income under section 103, 
and S incurs $60 of related expense for which a deduction is permanently 
disallowed under section 265.
    (b) Analysis. Under paragraph (b)(3)(i)(A) of this section, S has a 
$100 tax loss for Year 1. Under paragraph (b)(3)(ii)(A) of this section, 
S has $80 of tax-exempt income. Under paragraph (b)(3)(iii)(A) of this 
section, S has $60 of noncapital, nondeductible expense. Under paragraph 
(b)(3)(iv)(C) of this section, the tax-exempt income and noncapital, 
nondeductible expense are taken into account in Year 1 because that is 
the year they would be taken into account under S's method of accounting 
if they were subject to Federal income taxation. Thus, under paragraph 
(b) of this section, P reduces its basis in S's stock as of the close of 
Year 1 by an $80 net amount (the $100 tax loss, less $80 of tax-exempt 
income, plus $60 of noncapital, nondeductible expenses).
    Example 4. Discharge of indebtedness.  (a), (b), and (c) [Reserved]. 
For further guidance, see Sec. 1.1502-32T(b)(5)(ii), Example 4(a), (b), 
and (c).
    (d) Purchase price adjustment. Assume instead that S buys land in 
Year 1 in exchange for S's $100 purchase money note (bearing interest at 
a market rate of interest in excess of the applicable Federal rate, and 
providing for a principal payment at the end of Year 10), and the seller 
agrees with S in Year 4 to discharge $60 of the note as a purchase price 
adjustment to which section 108(e)(5) applies. S has no discharge of 
indebtedness income that is treated as tax-exempt income under paragraph 
(b)(3)(ii) of this section. In addition, the $60 purchase price 
adjustment is not a noncapital, nondeductible expense under paragraph 
(b)(3)(iii) of this section. A purchase price adjustment is not 
equivalent to a discharge of indebtedness that is offset by a deduction 
or loss. Consequently, the purchase price adjustment results in no net 
adjustment to P's basis in S's stock under paragraph (b) of this 
section.
    Example 5. Distributions. (a) Amounts declared and distributed. For 
Year 1, the P group has $120 of consolidated taxable income when 
determined by including only S's items of income, gain, deduction, and 
loss taken into account. S declares and makes a $10 dividend 
distribution to P at the close of Year 1. Under paragraph (b) of this 
section, P increases its basis in S's stock as of the close of Year 1 by 
a $110 net amount ($120 of taxable income, less a $10 distribution).
    (b) Distributions in later years. The facts are the same as in 
paragraph (a) of this Example 5, except that S does not declare and 
distribute the $10 until Year 2. Under paragraph (b) of this section, P 
increases its basis in S's stock by $120 as of the close of Year 1, and

[[Page 386]]

decreases its basis by $10 as of the close of Year 2. (If P were also a 
subsidiary, the basis of its stock would also be increased in Year 1 to 
reflect P's $120 adjustment to basis of S's stock; the basis of P's 
stock would not be changed as a result of S's distribution in Year 2, 
because P's $10 of tax-exempt dividend income under paragraph (b)(3)(ii) 
of this section would be offset by the $10 negative adjustment to P's 
basis in S's stock for the distribution.)
    (c) Amounts declared but not distributed. The facts are the same as 
in paragraph (a) of this Example 5, except that, during December of Year 
1, S declares (and P becomes entitled to) another $70 dividend 
distribution with respect to its stock, but P does not receive the 
distribution until after it sells all of S's stock at the close of Year 
1. Under Sec. 1.1502-13(f)(2)(iv), S is treated as making a $70 
distribution to P at the time P becomes entitled to the distribution. 
(If S is distributing an appreciated asset, its gain under section 311 
is also taken into account under paragraph (b)(3)(i) of this section at 
the time P becomes entitled to the distribution.) Consequently, under 
paragraph (b) of this section, P increases its basis in S's stock as of 
the close of Year 1 by only a $40 net amount ($120 of taxable income, 
less two distributions totalling $80). Any further adjustments after S 
ceases to be a member and the $70 distribution is made would be 
duplicative, because the stock basis has already been adjusted for the 
distribution. Accordingly, the distribution will not result in further 
adjustments or gain, even if the distribution is a payment to which 
section 301(c)(2) or (3) applies.
    Example 6. Reorganization with boot. (a) Facts. P owns all of the 
stock of S and T. On January 1 of Year 1, P has a $100 basis in the S 
stock and a $60 basis in the T stock. S and T have no items of income, 
gain, deduction, or loss for Year 1. S and T each have substantial 
earnings and profits. At the close of Year 1, T merges into S in a 
reorganization described in section 368(a)(1)(A) (and in section 
368(a)(1)(D)). P receives no additional S stock, but does receive $10 
which is treated as a dividend under section 356(a)(2).
    (b) Analysis. Under section 358, P's basis in the S stock is 
increased by its basis in the T stock. Under Sec. 1.1502-13(f)(3) the 
money received is treated as being taken into account immediately after 
the transaction. Thus, the $10 is treated as a dividend distribution 
under section 301 and under paragraph (b)(3)(v) of this section, the $10 
is a distribution to which paragraph (b)(2)(iv) of this section applies. 
Accordingly, P's basis in the S stock is $160 immediately after the 
merger, which is then decreased by the $10 distribution taken into 
account immediately after the transaction, resulting in a basis of $150.
    Example 7. Tiering up of basis adjustments. P owns all of S's stock, 
and S owns all of T's stock. For Year 1, the P group has $100 of 
consolidated taxable income when determined by including only T's items 
of income, gain, deduction, and loss taken into account, and $50 of 
consolidated taxable income when determined by including only S's items 
taken into account. S increases its basis in T's stock by $100 under 
paragraph (b) of this section. Under paragraph (a)(3) of this section, 
this $100 basis adjustment is taken into account in determining P's 
adjustments to its basis in S's stock. Thus, P increases its basis in 
S's stock by $150 under paragraph (b) of this section.
    Example 8. Allocation of items. (a) Acquisition in mid-year. P is 
the common parent of a consolidated group, and S is an unaffiliated 
corporation filing separate returns on a calendar-year basis. P acquires 
all of S's stock and S becomes a member of the P group on July 1 of Year 
1. For the entire calendar Year 1, S has $100 of ordinary income and 
under Sec. 1.1502-76(b) $60 is allocated to the period from January 1 
to June 30 and $40 to the period from July 1 to December 31. Under 
paragraph (b) of this section, P increases its basis in S's stock by 
$40.
    (b) Sale in mid-year. The facts are the same as in paragraph (a) of 
this Example 8, except that S is a member of the P group at the 
beginning of Year 1 but ceases to be a member on June 30 as a result of 
P's sale of S's stock. Under paragraph (b) of this section, P increases 
its basis in S's stock by $60 immediately before the stock sale. (P's 
basis increase would be the same if S became a nonmember because S 
issued additional shares to nonmembers.)
    (c) Absorption of loss carryovers. Assume instead that S is a member 
of the P group at the beginning of Year 1 but ceases to be a member on 
June 30 as a result of P's sale of S's stock, and a $100 consolidated 
net operating loss attributable to S is carried over by the P group to 
Year 1. The consolidated net operating loss may be apportioned to S for 
its first separate return year only to the extent not absorbed by the P 
group during Year 1. Under paragraph (b)(3)(i) of this section, if the 
loss is absorbed by the P group in Year 1, whether the offsetting income 
arises before or after P's sale of S's stock, the absorption of the loss 
carryover is included in the determination of S's taxable income or loss 
for Year 1. Thus, P's basis in S's stock is adjusted under paragraph (b) 
of this section to reflect any absorption of the loss by the P group.
    Example 9. Gross-ups. (a) Facts. P owns all of the stock of S, and S 
owns all of the stock of T, a newly formed controlled foreign 
corporation that is not a passive foreign investment company. In Year 1, 
T has $100 of subpart F income and pays $34 of foreign income tax, 
leaving T with $66 of earnings and profits. The P group has $100 of 
consolidated taxable income when determined by taking into

[[Page 387]]

account only S's items (the inclusion under section 951(a), taking into 
account the section 78 gross-up). As a result of the section 951(a) 
inclusion, S increases its basis in T's stock by $66 under section 
961(a).
    (b) Analysis. Under paragraph (b)(3)(i) of this section, S has $100 
of taxable income. Under paragraph (b)(3)(iii)(B) of this section, the 
$34 gross-up for taxes paid by T that S is treated as having paid is a 
noncapital, nondeductible expense (whether or not any corresponding 
amount is claimed by the P group as a tax credit). Thus, P increases its 
basis in S's stock under paragraph (b) of this section by the net 
adjustment of $66.
    (c) Subsequent distribution. The facts are the same as in paragraph 
(a) of this Example 9, except that T distributes its $66 of earnings and 
profits in Year 2. The $66 distribution received by S is excluded from 
S's income under section 959(a) because the distribution represents 
earnings and profits attributable to amounts that were included in S's 
income under section 951(a) for Year 1. In addition, S's basis in T's 
stock is decreased by $66 under section 961(b). The excluded 
distribution is not tax-exempt income under paragraph (b)(3)(ii) of this 
section because of the corresponding reduction to S's basis in T's 
stock. Consequently, P's basis in S's stock is not adjusted under 
paragraph (b) of this section for Year 2.
    Example 10. Recapture of tax-exempt items. (a) Facts. S is a life 
insurance company. For Year 1, the P group has $200 of consolidated 
taxable income, determined by including only S's items of income, gain, 
deduction, and loss taken into account (including a $300 small company 
deduction under section 806). In addition, S has $100 of tax-exempt 
interest income, $60 of which is S's company share. The remaining $40 of 
tax-exempt income is the policyholders' share that reduces S's deduction 
for increase in reserves.
    (b) Tax-exempt items generally. Under paragraph (b)(3)(i) of this 
section, S has $200 of taxable income for Year 1. Also for Year 1, S has 
$100 of tax-exempt income under paragraph (b)(3)(ii)(A) of this section, 
and another $300 is treated as tax-exempt income under paragraph 
(b)(3)(ii)(B) of this section because of the deduction under section 
806. Under paragraph (b)(3)(iii) of this section, S has $40 of 
noncapital, nondeductible expenses for Year 1 because S's deduction 
under section 807 for its increase in reserves has been permanently 
reduced by the $40 policyholders' share of the tax-exempt interest 
income. Thus, P increases its basis in S's stock by $560 under paragraph 
(b) of this section.
    (c) Recapture. Assume instead that S is a property and casualty 
company and, for Year 1, S accrues $100 of estimated salvage recoverable 
under section 832. Of this amount, $87 (87% of $100) is excluded from 
gross income because of the ``fresh start'' provisions of Sec. 11305(c) 
of P.L. 101-508 (the Omnibus Budget Reconciliation Act of 1990). Thus, S 
has $87 of tax-exempt income under paragraph (b)(3)(ii)(A) of this 
section that increases P's basis in S's stock for Year 1. (S also has 
$13 of taxable income over the period of inclusion under section 481.) 
In Year 5, S determines that the $100 salvage recoverable was 
overestimated by $30 and deducts $30 for the reduction of the salvage 
recoverable. However, S has $26.10 (87% of $30) of taxable income in 
Year 5 due to the partial recapture of its fresh start. Because S has no 
basis corresponding to this income, S is treated under paragraph 
(b)(3)(iii)(B) of this section as having a $26.10 noncapital, 
nondeductible expense in Year 5. This treatment is necessary to reflect 
the elimination of the erroneous fresh start in S's stock basis and 
causes a decrease in P's basis in S's stock by $30 for Year 5 (a $3.90 
taxable loss and a $26.10 special adjustment).

    (c) Allocation of adjustments among shares of stock--(1) In general. 
The portion of the adjustment under paragraph (b) of this section that 
is described in paragraph (b)(2)(iv) of this section (negative 
adjustments for distributions) is allocated to the shares of S's stock 
to which the distribution relates. The remainder of the adjustment, 
described in paragraphs (b)(2)(i) through (iii) of this section 
(adjustments for taxable income or loss, tax-exempt income, and 
noncapital, nondeductible expenses), is allocated among the shares of 
S's stock as provided in paragraphs (c)(2) through (4) of this section. 
If the remainder of the adjustment is positive, it is allocated first to 
any preferred stock to the extent provided in paragraph (c)(3) of this 
section, and then to the common stock as provided in paragraph (c)(2) of 
this section. If the remainder of the adjustment is negative, it is 
allocated only to common stock as provided in paragraph (c)(2) of this 
section. An adjustment under this section allocated to a share for the 
period the share is owned by a nonmember has no effect on the basis of 
the share. See paragraph (c)(4) of this section for the reallocation of 
adjustments, and paragraph (d) of this section for definitions. See 
Sec. 1.1502-19(d) for special allocations of basis determined or 
adjusted under the Code with respect to excess loss accounts.
    (2) Common stock--(i) Allocation within a class. The portion of the 
adjustment described in paragraphs (b)(2)(i)

[[Page 388]]

through (iii) of this section (the adjustment determined without taking 
distributions into account) that is allocable to a class of common stock 
is generally allocated equally to each share within the class. However, 
if a member has an excess loss account in shares of a class of common 
stock at the time of a positive adjustment, the portion of the 
adjustment allocable to the member with respect to the class is 
allocated first to equalize and eliminate that member's excess loss 
accounts and then to increase equally its basis in the shares of that 
class. Similarly, any negative adjustment is allocated first to reduce 
the member's positive basis in shares of the class before creating or 
increasing its excess loss account. Distributions and any adjustments or 
determinations under the Internal Revenue Code (e.g., under section 358, 
including any modifications under Sec. 1.1502-19(d)) are taken into 
account before the allocation is made under this paragraph (c)(2)(i).
    (ii) Allocation among classes--(A) General rule. If S has more than 
one class of common stock, the extent to which the adjustment described 
in paragraphs (b)(2)(i) through (iii) of this section (the adjustment 
determined without taking distributions into account) is allocated to 
each class is determined, based on consistently applied assumptions, by 
taking into account the terms of each class and all other facts and 
circumstances relating to the overall economic arrangement. The 
allocation generally must reflect the manner in which the classes 
participate in the economic benefit or burden (if any) corresponding to 
the items of income, gain, deduction, or loss allocated. In determining 
participation, any differences in voting rights are not taken into 
account, and the following factors are among those to be considered--
    (1) The interest of each share in economic profits and losses (if 
different from the interest in taxable income);
    (2) The interest of each share in cash flow and other non-
liquidating distributions; and
    (3) The interest of each share in distributions in liquidation.
    (B) Distributions and Code adjustments. Distributions and any 
adjustments or determinations under the Internal Revenue Code are taken 
into account before the allocation is made under this paragraph 
(c)(2)(ii).
    (3) Preferred stock. If the adjustment under paragraphs (b)(2)(i) 
through (iii) of this section (the adjustment determined without taking 
distributions into account) is positive, it is allocated to preferred 
stock to the extent required (when aggregated with prior allocations to 
the preferred stock during the period that S is a member of the 
consolidated group) to reflect distributions described in section 301 
(and all other distributions treated as dividends) to which the 
preferred stock becomes entitled, and arrearages arising, during the 
period that S is a member of the consolidated group. For this purpose, 
the preferred stock is treated as entitled to a distribution no later 
than the time the distribution is taken into account under the Internal 
Revenue Code (e.g., under section 305). If the amount of distributions 
and arrearages exceeds the positive amount (when aggregated with prior 
allocations), the positive amount is first allocated among classes of 
preferred stock to reflect their relative priorities, and the amount 
allocated to each class is then allocated pro rata within the class. An 
allocation to a share with respect to arrearages and distributions for 
the period the share is owned by a nonmember is not reflected in the 
basis of the share under paragraph (b) of this section. However, if P 
and S cease to be members of one consolidated group and remain 
affiliated as members of another consolidated group, P's ownership of 
S's stock during consolidated return years of the prior group is treated 
for this purpose as ownership by a member to the extent that the 
adjustments during the prior consolidated return years are still 
reflected in the basis of the preferred stock.
    (4) Cumulative redetermination--(i) General rule. A member's basis 
in each share of S's preferred and common stock must be redetermined 
whenever necessary to determine the tax liability of any person. See 
paragraph (b)(1) of this section. The redetermination is made by 
reallocating S's net adjustment described in paragraphs (b)(2)(i)

[[Page 389]]

through (iii) of this section (the adjustment determined without taking 
distributions into account) for each consolidated return year (or other 
applicable period) of the group by taking into account all of the facts 
and circumstances affecting allocations under this paragraph (c) as of 
the redetermination date with respect to all of S's shares. For this 
purpose:
    (A) Amounts may be reallocated from one class of S's stock to 
another class, but not from one share of a class to another share of the 
same class.
    (B) If there is a change in the equity structure of S (e.g., as the 
result of S's issuance, redemption, or recapitalization of shares), a 
cumulative redetermination is made for the period before the change. If 
a reallocation is required by another redetermination after a change, 
amounts arising after the change are reallocated before amounts arising 
before the change.
    (C) If S becomes a nonmember as a result of a change in its equity 
structure, any reallocation is made only among the shares of S's stock 
immediately before the change. For example, if S issues stock to a 
nonmember creditor in exchange for its debt, and the exchange results in 
S becoming a nonmember, any reallocation is only among the shares of S's 
stock immediately before the exchange.
    (D) Any reallocation is treated for all purposes after it is made 
(including subsequent redeterminations) as the original allocation of an 
amount under this paragraph (c), but the reallocation does not affect 
any prior period.
    (ii) Prior use of allocations. An amount may not be reallocated 
under paragraph (c)(4)(i) of this section to the extent that the amount 
has been used before the reallocation. For this purpose, an amount has 
been used to the extent it has been taken into account, directly or 
indirectly, by any member in determining income, gain, deduction, or 
loss, or in determining the basis of any property that is not subject to 
this section (e.g., stock of a corporation that has become a nonmember). 
For example, if P sells a share of S stock, an amount previously 
allocated to the share cannot be reallocated to another share of S 
stock, but an amount allocated to another share of S stock can still be 
reallocated to the sold share because the reallocated amount has not 
been taken into account; however, any adjustment reallocated to the sold 
share may effectively be eliminated, because the reallocation was not in 
effect when the share was previously sold and P's gain or loss from the 
sale is not redetermined. If, however, P sells the share of S stock to 
another member, the amount is not used until P's gain or loss is taken 
into account under Sec. 1.1502-13.
    (5) Examples. The principles of this paragraph (c) are illustrated 
by the following examples.

    Example 1. Ownership of less than all the stock. (a) Facts. P owns 
80% of S's only class of stock with an $800 basis. For Year 1, S has 
$100 of taxable income.
    (b) Analysis. Under paragraph (c)(1) of this section, the $100 
positive adjustment under paragraph (b) of this section for S's taxable 
income is allocated among the shares of S's stock, including shares 
owned by nonmembers. Under paragraph (c)(2)(i) of this section, the 
adjustment is allocated equally to each share of S's stock. Thus, P 
increases its basis in S's stock under paragraph (b) of this section as 
of the close of Year 1 by $80. (The basis of the 20% of S's stock owned 
by nonmembers is not adjusted under this section.)
    (c) Varying interest. The facts are the same as in paragraph (a) of 
this Example 1, except that P buys the remaining 20% of S's stock at the 
close of business on June 30 of Year 1 for $208. Under paragraph (b)(1) 
of this section and the principles of Sec. 1.1502-76(b), S's $100 of 
taxable income is allocable $40 to the period from January 1 to June 30 
and $60 to the period from July 1 to December 31. Thus, for the period 
ending June 30, P is treated as having a $32 adjustment with respect to 
the S stock that P has owned since January 1 (80% of $40) and, under 
paragraph (c)(2)(i) of this section, the adjustment is allocated equally 
among those shares. For the period ending December 31, P is treated as 
having a $60 adjustment (100% of $60) that is also allocated equally 
among P's shares of S's stock owned after June 30. P's basis in the 
shares owned as of the beginning of the year therefore increases by $80 
(the sum of 80% of $40 and 80% of $60), from $800 to $880, and P's basis 
in the shares purchased on June 30 increases by $12 (20% of $60), from 
$208 to $220. Thus, P's aggregate basis in S's stock as of the end of 
Year 1 is $1,100.
    (d) Tax liability. The facts are the same as in paragraph (a) of 
this Example 1, except that P pays S's $34 share of the group's 
consolidated tax liability resulting from S's taxable income, and S does 
not reimburse P. S's $100 of taxable income results in a positive

[[Page 390]]

adjustment under paragraph (b)(3)(i) of this section, and S's $34 of tax 
liability results in a negative adjustment under paragraph (b)(3)(iv)(D) 
of this section and the principles of section 1552. Because S does not 
make any payment in recognition of the additional tax liability, by 
analogy to the treatment under Sec. 1.1552-1(b)(2), S is treated as 
having made a $34 payment that is described in paragraph (b)(3)(iii) of 
this section (noncapital, nondeductible expenses) and as having received 
an equal amount from P as a capital contribution. Thus, P increases its 
basis in its S stock by $52.80 (80% of the $100 of taxable income, less 
80% of the $34 tax payment). In addition, P increases its basis in S's 
stock by $34 under the Internal Revenue Code and paragraph (a)(2) of 
this section to reflect the capital contribution. In the aggregate, P 
increases its basis in S's stock by $86.80. (If, as in paragraph (c) of 
this Example 1, P buys the remaining 20% of S's stock at the close of 
business on June 30, P increases its basis in S's stock by another $7.90 
for the additional 20% interest in S's income after June 30 ($60 
multiplied by 20%, less 20% of the $20.40 tax payment on $60); the $34 
capital contribution by P is reflected in all of its S shares (not just 
the original 80%), and P's aggregate basis adjustment under this section 
is $94.70 ($86.80 plus $7.90).)
    Example 2. Preferred stock. (a) Facts. P owns all of S's common 
stock with an $800 basis, and nonmembers own all of S's preferred stock. 
The preferred stock was issued for $200, has a $20 annual, cumulative 
preference as to dividends, and has an initial liquidation preference of 
$200. For Year 1, S has $50 of taxable income and no distributions are 
declared or made.
    (b) Analysis of arrearages. Under paragraphs (c) (1) and (3) of this 
section, $20 of the $50 positive adjustment under paragraph (b) of this 
section is allocated first to the preferred stock to reflect the 
dividend arrearage arising in Year 1. The remaining $30 of the positive 
adjustment is allocated to the common stock, increasing P's basis from 
$800 to $830 as of the close of Year 1. (The basis of the preferred 
stock owned by nonmembers is not adjusted under this section.)
    (c) Current distribution. The facts are the same as in paragraph (a) 
of this Example 2, except that S declares and makes a $20 distribution 
with respect to the preferred stock during Year 1 in satisfaction of its 
preference. The results are the same as in paragraph (b) of this Example 
2.
    (d) Varying interest. The facts are the same as in paragraph (a) of 
this Example 2, except that S has no income or loss for Years 1 and 2, P 
purchases all of S's preferred stock at the beginning of Year 3 for 
$240, and S has $70 of taxable income for Year 3. Under paragraph (c)(3) 
of this section, $60 of the $70 positive adjustment under paragraph (b) 
of this section is allocated to the preferred stock to reflect the 
dividends arrearages for Years 1 through 3, but only the $20 for Year 3 
is reflected in the basis of the preferred stock under paragraph (b) of 
this section. (The remaining $40 is not reflected because the preferred 
stock was owned by nonmembers during Years 1 and 2.) Thus, P increases 
its basis in S's preferred stock from $240 to $260, and its basis in S's 
common stock from $800 to $810, as of the close of Year 3. (If P had 
acquired all of S's preferred stock in a transaction to which section 
351 applies, and P's initial basis in S's preferred stock was $200 under 
section 362, P's basis in S's preferred stock would increase from $200 
to $220.)
    (e) Varying interest with current distributions. The facts are the 
same as in paragraph (d) of this Example 2, except that S declares and 
makes a $20 distribution with respect to the preferred stock in each of 
Years 1 and 2 in satisfaction of its preference, and P purchases all of 
S's preferred stock at the beginning of Year 3 for $200. Under paragraph 
(c)(3) of this section, $40 of the $70 positive adjustment under 
paragraph (b) of this section is allocated to the preferred stock to 
reflect the distributions in Years 1 and 2, and $20 of the $70 is 
allocated to the preferred stock to reflect the arrearage for Year 3. 
However, as in paragraph (d) of this Example 2, only the $20 
attributable to Year 3 is reflected in the basis of the preferred stock 
under paragraph (b) of this section. Thus, P increases its basis in S's 
preferred stock from $200 to $220, and P increases its basis in S's 
common stock from $800 to $810.
    Example 3. Cumulative redetermination. (a) Facts. P owns all of S's 
common and preferred stock. The preferred stock has a $100 annual, 
cumulative preference as to dividends. For Year 1, S has $200 of taxable 
income, the first $100 of which is allocated to the preferred stock and 
the remaining $100 of which is allocated to the common stock. For Year 
2, S has no adjustment under paragraph (b) of this section, and P sells 
all of S's common stock at the close of Year 2.
    (b) Analysis. Under paragraph (c)(4) of this section, P's basis in 
S's common stock must be redetermined as of the sale of the stock. The 
redetermination is made by reallocating the $200 positive adjustment 
under paragraph (b) of this section for Year 1 by taking into account 
all of the facts and circumstances affecting allocations as of the sale. 
Thus, the $200 positive adjustment for Year 1 is reallocated entirely to 
the preferred stock to reflect the dividend arrearages for Years 1 and 
2. The reallocation away from the common stock reflects the fact that, 
because of the additional amount of arrearage in Year 2, the common 
stock is not entitled to any part of the $200 of taxable income from 
Year 1. Thus, the common stock has no positive or negative adjustment, 
and the preferred stock

[[Page 391]]

has a $200 positive adjustment. These reallocations are treated as the 
original allocations for Years 1 and 2. (The results for the common 
stock would be the same if the common and preferred stock were not owned 
by the same member, or the preferred stock were owned by nonmembers.)
    (c) Preferred stock issued after adjustment arises. The facts are 
the same as in paragraph (a) of this Example 3, except that S does not 
issue its preferred stock until the beginning of Year 2, S has no 
further adjustment under paragraph (b) of this section for Years 2 and 
3, and P sells S's common stock at the close of Year 3. Under paragraphs 
(c) (1) and (2) of this section, the $200 positive adjustment for Year 1 
is initially allocated entirely to the common stock. Under paragraph 
(c)(4) of this section, the $200 adjustment is reallocated to the 
preferred stock to reflect the arrearages for Years 2 and 3. Thus, the 
common stock has no positive or negative adjustment.
    (d) Common stock issued after adjustment arises. The facts are the 
same as in paragraph (a) of this Example 3, except that S has no 
preferred stock, S issues additional common stock of the same class at 
the beginning of Year 2, S has no further adjustment under paragraph (b) 
of this section in Years 2 and 3, and P sells its S common stock at the 
close of Year 3. Under paragraphs (c) (1) and (2) of this section, the 
$200 positive adjustment for Year 1 is initially allocated entirely to 
the original common stock. Under paragraph (c)(4)(i)(A) of this section, 
the $200 adjustment is not reallocated among the original common stock 
and the additional stock. Unlike the preferred stock in paragraph (c) of 
this Example 3, the additional common stock is of the same class as the 
original stock, and there is no reallocation between shares of the same 
class.
    (e) Positive and negative adjustments. The facts are the same as in 
paragraph (a) of this Example 3, except that S has a $200 loss for Year 
2 that results in a negative adjustment to the common stock before any 
redetermination. For purposes of the basis redetermination under 
paragraph (c)(4) of this section, the Year 1 and 2 adjustments under 
paragraph (b) of this section are not netted. Thus, as in paragraph (b) 
of this Example 3, the redetermination is made by reallocating the $200 
positive adjustment for Year 1 entirely to the preferred stock. The $200 
negative adjustment for Year 2 is allocated entirely to the common 
stock. Consequently, the preferred stock has a $200 positive cumulative 
adjustment, and the common stock has a $200 negative cumulative 
adjustment. (The results would be the same if there were no other 
adjustments described in paragraph (b) of this section, P sells S's 
common stock at the close of Year 3 rather than Year 2, and an 
additional $100 arrearage arises in Year 3; only adjustments under 
paragraph (b) of this section may be reallocated, and there is no 
additional adjustment for Year 3.)
    (f) Current distributions. The facts are the same as in paragraph 
(a) of this Example 3, except that, during Year 1, S declares and makes 
a distribution to P of $100 as a dividend on the preferred stock and 
$100 as a dividend on the common stock. The taxable income and 
distributions result in no Year 1 adjustment under paragraph (b) of this 
section for either the common or preferred stock. For example, if T 
merges into S, S is treated, as the context may require, as a successor 
to T and as becoming a member of the group. However, as in paragraph (b) 
of this Example 3, the redetermination under paragraph (c)(4) of this 
section is made by reallocating a $200 positive adjustment for Year 1 
(S's net adjustment described in paragraph (b) of this section, 
determined without taking distributions into account) to the preferred 
stock. Consequently, the preferred stock has a $100 positive cumulative 
adjustment ($200 of taxable income, less a $100 distribution with 
respect to the preferred stock) and the common stock has a $100 negative 
cumulative adjustment (for the distribution).
    (g) Convertible preferred stock. The facts are the same as in 
paragraph (a) of this Example 3, except that the preferred stock is 
convertible into common stock that is identical to the common stock 
already outstanding, the holders of the preferred stock convert the 
stock at the close of Year 2, and no stock is sold until the close of 
Year 5. Under paragraph (c)(4) of this section, the $200 positive 
adjustment for Year 1 is reallocated entirely to the preferred stock 
immediately before the conversion. The newly issued common stock is 
treated as a second class of S common stock, and adjustments under 
paragraph (b) of this section are allocated between the original and the 
new common stock under paragraph (c)(2)(ii) of this section. Although 
the preferred stock is converted to common stock, the $200 adjustment to 
the preferred stock is not subsequently reallocated between the original 
and the new common stock. Because the original and the new stock are 
equivalent, adjustments under paragraph (b) of this section for 
subsequent periods are allocated equally to each share.
    (h) Prior use of allocations. The facts are the same as in paragraph 
(a) of this Example 3, except that P sells 10% of S's common stock at 
the close of Year 1, and the remaining 90% at the close of Year 2. P's 
basis in the common stock sold in Year 1 reflects $10 of the adjustment 
allocated to the common stock for Year 1. Under paragraph (c)(4)(ii) of 
this section, because $10 of the Year 1 adjustment was used in 
determining P's gain or loss, only $90 is reallocated to the preferred 
stock, and $10 remains allocated to the common stock sold.

[[Page 392]]

    (i) Lower-tier members. The facts are the same as in paragraph (a) 
of this Example 3, except that P owns only S's common stock, and P is 
also a subsidiary. If there is a redetermination under paragraph (c)(4) 
of this section by a member owning P's stock, a redetermination with 
respect to S's stock must be made first, and the effect of that 
redetermination on P's adjustments is taken into account under paragraph 
(b) of this section. However, as in paragraph (h) of this Example 3, to 
the extent an amount of the initial adjustments with respect to S's 
common stock have already been tiered up and used by a member owning P's 
stock, that amount remains with S's common stock (and the higher-tier 
member using the adjustment with respect to P's stock), and may not be 
reallocated to S's preferred stock.
    Example 4. Allocation to preferred stock between groups. (a) Facts. 
P owns all of S's only class of stock, and S owns all of T's common and 
preferred stock. The preferred stock has a $100 annual, cumulative 
preference as to dividends. For Year 1, T has $200 of taxable income, 
the first $100 of which is allocated to the preferred stock and the 
remaining $100 of which is allocated to the common stock, and S has no 
adjustments other than the amounts tiered up from T. S and T have no 
adjustments under paragraph (b) of this section for Years 2 and 3. X, 
the common parent of another consolidated group, purchases all of S's 
stock at the close of Year 3, and S and T become members of the X group. 
For Year 4, T has $200 of taxable income, and S has no adjustments other 
than the amounts tiered up from T.
    (b) Analysis for Years 1 through 3. Under paragraph (c)(4) of this 
section, the allocation of S's adjustments under paragraph (b) of this 
section (determined without taking distributions into account) must be 
redetermined as of the time P sells S's stock. As a result of this 
redetermination, T's common stock has no positive or negative adjustment 
and the preferred stock has a $200 positive adjustment.
    (c) Analysis for Year 4. Under paragraph (c)(3) of this section, the 
allocation of T's $200 positive adjustment in Year 4 to T's preferred 
stock with respect to arrearages is made by taking into account the 
consolidated return years of both the P group and the X group. Thus, the 
allocation of the $200 positive adjustment for Year 4 to T's preferred 
stock is not treated as an allocation for a period for which the 
preferred stock is owned by a nonmember. Thus, the $200 adjustment is 
reflected in S's basis in T's preferred stock under paragraph (b) of 
this section.

    (d) Definitions. For purposes of this section--
    (1) Class. The shares of a member having the same material terms 
(without taking into account voting rights) are treated as a single 
class of stock.
    (2) Preferred stock. Preferred stock is stock that is limited and 
preferred as to dividends and has a liquidation preference. A class of 
stock that is not described in section 1504(a)(4), however, is not 
treated as preferred stock for purposes of paragraph (c) of this section 
if members own less than 80% of each class of common stock (determined 
without taking this paragraph (d)(2) into account).
    (3) Common stock. Common stock is stock that is not preferred stock.
    (4) Becoming a nonmember. A member is treated as becoming a 
nonmember if it has a separate return year (including another group's 
consolidated return year). For example, S may become a nonmember if it 
issues additional stock to nonmembers, but S does not become a nonmember 
as a result of its complete liquidation.
    (e) Anti-avoidance rule--(1) General rule. If any person acts with a 
principal purpose contrary to the purposes of this section, to avoid the 
effect of the rules of this section or apply the rules of this section 
to avoid the effect of any other provision of the consolidated return 
regulations, adjustments must be made as necessary to carry out the 
purposes of this section.
    (2) Examples. The principles of this paragraph (e) are illustrated 
by the following examples.

    Example 1. Preferred stock treated as common stock. (a) Facts. S has 
100 shares of common stock and 100 shares of preferred stock described 
in section 1504(a)(4). P owns 80 shares of S's common stock and all of 
S's preferred stock. The shareholders expect that S will have negative 
adjustments under paragraph (b) of this section for Years 1 and 2 (all 
of which will be allocable to S's common stock), the negative 
adjustments will have no significant effect on the value of S's stock, 
and S will have offsetting positive adjustments thereafter. When the 
preferred stock was issued, P intended to cause S to recapitalize the 
preferred stock into additional common stock at the end of Year 2 in a 
transaction described in section 368(a)(1)(E). P's temporary ownership 
of the preferred stock is with a principal purpose to limit P's basis 
reductions under paragraph (b) of this section to 80% of the anticipated 
negative adjustments. The recapitalization is intended to cause 
significantly more than 80% of the anticipated positive adjustments

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to increase P's basis in S's stock because of P's increased ownership of 
S's common stock immediately after the recapitalization.
    (b) Analysis. S has established a transitory capital structure with 
a principal purpose to enhance P's basis in S's stock under this 
section. Under paragraph (e)(1) of this section, all of S's common and 
preferred stock is treated as a single class of common stock in Years 1 
and 2 for purposes of this section. Thus, S's items are allocated under 
the principles of paragraph (c)(2)(ii) of this section, and P decreases 
its basis in both the common and preferred stock accordingly.
    Example 2. Contribution of appreciated property. (a) Facts. P owns 
all of the stock of S and T, and S and T each own 50% of the stock of U. 
P's S stock has a $150 basis and $200 value, and P's T stock has a $200 
basis and $200 value. With a principal purpose to eliminate P's gain 
from an anticipated sale of S's stock, T contributes to U an asset with 
a $100 value and $0 basis, and S contributes $100 cash. U sells T's 
asset and recognizes a $100 gain that results in a $100 positive 
adjustment under paragraph (b) of this section.
    (b) Analysis. Under paragraph (c)(2) of this section, U's adjustment 
ordinarily would be allocated equally to each share of U's stock. If so 
allocated, P's basis in S's stock would increase from $150 to $200 and P 
would recognize no gain from the sale of S's stock for $200. Under 
paragraph (e)(1) of this section, however, because T transferred an 
appreciated asset to U with a principal purpose to shift a portion of 
the stock basis increase from P's stock in T to P's stock in S, the 
allocation of the $100 positive adjustment under paragraph (c) of this 
section between the shares of U's stock must take into account the 
contribution. Consequently, all $100 of the positive adjustment is 
allocated to the U stock owned by T, rather than $50 to the U stock 
owned by S and $50 to the U stock owned by T. P's basis in S's stock 
remains $150, and its basis in T's stock increases to $300. Thus, P 
recognizes a $50 gain from its sale of S's stock for $200.
    Example 3. Reorganizations. (a) Facts. P forms S with an $800 
contribution, $200 of which is in exchange for S's preferred stock 
described in section 1504(a)(4) and the balance of which is for S's 
common stock. For Years 1 through 3, S has a total of $160 of ordinary 
income, $60 of which is distributed with respect to the preferred stock 
in satisfaction of its $20 annual preference as to dividends. Under this 
section, P's basis in S's preferred stock is unchanged, and its basis in 
S's common stock is increased from $600 to $700. To reduce its gain from 
an anticipated sale of S's preferred stock, P forms T at the close of 
Year 3 with a contribution of all of S's stock in exchange for 
corresponding common and preferred stock of T in a transaction to which 
section 351 applies. At the time of the contribution, the fair market 
value of the common stock is $700 and the fair market value of the 
preferred stock is $300 (due to a decrease in prevailing market interest 
rates). P subsequently sells T's preferred stock for $300.
    (b) Analysis. Under section 358(b), P ordinarily has a $630 basis in 
T's common stock (70% of the $900 aggregate stock basis) and a $270 
basis in T's preferred stock (30% of the $900 aggregate stock basis). 
However, because P transferred S's stock to T with a principal purpose 
to shift the allocation of basis adjustments under this section, 
adjustments are made under paragraph (e)(1) of this section to preserve 
the allocation under this section. Thus, P has a $700 basis in T's 
common stock and a $200 basis in T's preferred stock. Consequently, P 
recognizes a $100 gain from the sale of T's preferred stock.
    Example 4. Post-deconsolidation basis adjustments. (a) Facts. For 
Year 1, the P group has $40 of taxable income when determined by 
including only S's items of income, gain, deduction, and loss taken into 
account, and P increases its basis in S's stock by $40 under paragraph 
(b) of this section. P anticipates that S will have a $40 ordinary loss 
for Year 2 that will be carried back and offset S's income in Year 1 and 
result in a $40 reduction to P's basis in S's stock for Year 2 under 
paragraph (b) of this section. With a principal purpose to avoid the 
reduction, P causes S to issue voting preferred stock that results in S 
becoming a nonmember at the beginning of Year 2. As anticipated, S has a 
$40 loss for Year 2, which is carried back to Year 1 and offsets S's 
income from Year 1.
    (b) Analysis. Under paragraph (e)(1) of this section, because P 
caused S to become a nonmember with a principal purpose to absorb S's 
loss but avoid the corresponding negative adjustment under this section, 
and P bears a substantial portion of the loss because of its continued 
ownership of S common stock, the basis of P's common stock in S is 
decreased by $40 for Year 2. (If P has less than a $40 basis in the 
retained S stock, P must recognize income for Year 2 to the extent of 
the excess.) Section 1504(a)(3) limits the ability of S to subsequently 
rejoin the P group's consolidated return.
    (c) Carryback to pre-consolidation year. The facts are the same as 
in paragraph (a) of this Example 4, except that P anticipates that S's 
loss will be carried back and absorbed in a separate return year of S 
before Year 1 (rather than to the P group's consolidated return for Year 
1). Although P causes S to become a nonmember with a principal purpose 
to avoid the negative adjustment under this section, and P bears a 
substantial portion of the loss because of its continued ownership of S 
common stock, both S's income and loss are taken into account under the 
separate return rules. Consequently, no one has acted with a principal 
purpose contrary to the purposes of this section, and no adjustments are

[[Page 394]]

necessary to carry out the purposes of this section.
    Example 5. Pre-consolidation basis adjustments. (a) Facts. P forms S 
with a $100 contribution, and S becomes a member of the P affiliated 
group which does not file consolidated returns. For Years 1 through 3, S 
earns $300. P anticipates that it will elect under section 1501 for the 
P group to begin filing consolidated returns in Year 5. In anticipation 
of filing consolidated returns, and to avoid the negative stock basis 
adjustment that would result under paragraph (b) of this section from 
distributing S's earnings after Year 5, P causes S to distribute $300 
during Year 4 as a qualifying dividend within the meaning of section 
243(b). There is no plan or intention to recontribute the funds to S 
after the distribution.
    (b) Analysis. Although S's distribution of $300 is with a principal 
purpose to avoid a corresponding negative adjustment under this section, 
the $300 was both earned and distributed entirely under the separate 
return rules. Consequently, P and S have not acted with a principal 
purpose contrary to the purposes of this section, and no adjustments are 
necessary to carry out the purposes of this section.

    (f) Predecessors and successors. For purposes of this section, any 
reference to a corporation or to a share of stock includes a reference 
to a successor or predecessor as the context may require. A corporation 
is a successor if the basis of its assets is determined, directly or 
indirectly, in whole or in part, by reference to the basis of another 
corporation (the predecessor). For example, if T merges into S, S is 
treated, as the context may require, as a successor to T and as becoming 
a member of the group. A share is a successor if its basis is 
determined, directly or indirectly, in whole or in part, by reference to 
the basis of another share (the predecessor).
    (g) Recordkeeping. Adjustments under this section must be reflected 
annually on permanent records (including work papers). See also section 
6001, requiring records to be maintained. The group must be able to 
identify from these permanent records the amount and allocation of 
adjustments, including the nature of any tax-exempt income and 
noncapital, nondeductible expenses, so as to permit the application of 
the rules of this section for each year.
    (h) Effective date--(1) General rule. This section applies with 
respect to determinations of the basis of the stock of a subsidiary 
(e.g., for determining gain or loss from a disposition of stock) in 
consolidated return years beginning on or after January 1, 1995. If this 
section applies, basis must be determined or redetermined as if this 
section were in effect for all years (including, for example, the 
consolidated return years of another consolidated group to the extent 
adjustments from those years are still reflected). For example, if the 
portion of a consolidated net operating loss carryover attributable to S 
expired in 1990 and is treated as a noncapital, nondeductible expense 
under paragraph (b) of this section, it is taken into account in tax 
years beginning on or after January 1, 1995 as a negative adjustment for 
1990. Any such determination or redetermination does not, however, 
affect any prior period. Thus, the negative adjustment for S's 
noncapital, nondeductible expense is not taken into account for tax 
years beginning before January 1, 1995.
    (2) Dispositions of stock before effective date--(i) In general. If 
P disposes of stock of S in a consolidated return year beginning before 
January 1, 1995, the amount of P's income, gain, deduction, or loss, and 
the basis reflected in that amount, are not redetermined under this 
section. See Sec. 1.1502-19 as contained in the 26 CFR part 1 edition 
revised as of April 1, 1994 for the definition of disposition, and 
paragraph (h)(5) of this section for the rules applicable to such 
dispositions.
    (ii) Lower-tier members. Although P disposes of S's stock in a tax 
year beginning before January 1, 1995, S's determinations or adjustments 
with respect to the stock of a lower-tier member with which it continues 
to file a consolidated return are redetermined in accordance with the 
rules of this section (even if they were previously taken into account 
by P and reflected in income, gain, deduction, or loss from the 
disposition of S's stock). For example, assume that P owns all of S's 
stock, S owns all of T's stock, and T owns all of U's stock. If S sells 
80% of T's stock in a tax year beginning before January 1, 1995 (the 
effective date), the amount of S's income, gain, deduction, or loss from 
the sale, and the stock basis adjustments reflected in that amount, are 
not redetermined if P

[[Page 395]]

sells S's stock after the effective date. If S sells the remaining 20% 
of T's stock after the effective date, S's stock basis adjustments with 
respect to that T stock are also not redetermined because T became a 
nonmember before the effective date. However, if T and U continue to 
file a consolidated return with each other and T sells U's stock after 
the effective date, T's stock basis adjustments with respect to U's 
stock are redetermined (even though some of those adjustments may have 
been taken into account by S in its prior sale of T's stock before the 
effective date).
    (iii) Deferred amounts. For purposes of this paragraph (h)(2), a 
disposition does not include a transaction to which Sec. 1.1502-13, 
Sec. 1.1502-13T, Sec. 1.1502-14, or Sec. 1.1502-14T applies. Instead, 
the transaction is deemed to occur as the income, gain, deduction, or 
loss (if any) is taken into account.
    (3) Distributions--(i) Deemed dividend elections. If there is a 
deemed distribution and recontribution pursuant to Sec. 1.1502-32(f)(2) 
as contained in the 26 CFR part 1 edition revised as of April 1, 1994 in 
a consolidated return year beginning before January 1, 1995, the deemed 
distribution and recontribution under the election are treated as an 
actual distribution by S and recontribution by P as provided under the 
election.
    (ii) Affiliated earnings and profits. This section does not apply to 
reduce the basis in S's stock as a result of a distribution of earnings 
and profits accumulated in separate return years, if the distribution is 
made in a consolidated return year beginning before January 1, 1995, and 
the distribution does not cause a negative adjustment under the 
investment adjustment rules in effect at the time of the distribution. 
See paragraph (h)(5) of this section for the rules in effect with 
respect to the distribution.
    (4) Expiring loss carryovers. If S became a member of a consolidated 
group in a consolidated return year beginning before January 1, 1995, 
and S had a loss carryover from a separate return limitation year at 
that time, the group does not treat any expiration of the loss carryover 
(even if in a tax year beginning on or after January 1, 1995) as a 
noncapital, nondeductible expense resulting in a negative adjustment 
under this section. If S becomes a member of a consolidated group in a 
consolidated return year beginning on or after January 1, 1995, and S 
has a loss carryover from a separate return limitation year at that 
time, adjustments with respect to the expiration are determined under 
this section.
    (5) Prior law--(i) In general. For prior determinations, see prior 
regulations under section 1502 as in effect with respect to the 
determination. See, e.g., Sec. Sec. 1.1502-32 and 1.1502-32T as 
contained in the 26 CFR part 1 edition revised as of April 1, 1994.
    (ii) Continuing basis reductions for certain deconsolidated 
subsidiaries. If a subsidiary ceases to be a member of a group in a 
consolidated return year beginning before January 1, 1995, and its basis 
was subject to reduction under Sec. 1.1502-32T or Sec. 1.1502-32(g) as 
contained in the 26 CFR part 1 edition revised as of April 1, 1994, its 
basis remains subject to reduction under those principles. For example, 
if S ceased to be a member in 1990, and P's basis in any retained S 
stock was subject to a basis reduction account, the basis remains 
subject to reduction. Similarly, if an election could be made to apply 
Sec. 1.1502-32T instead of Sec. 1.1502-32(g), the election remains 
available. However, Sec. Sec. 1.1502-32T and 1.1502-32(g) do not apply 
as a result of a subsidiary ceasing to be a member in tax years 
beginning on or after January 1, 1995.
    (6) [Reserved]. For further guidance, see Sec. 1.1502-32T(h)(6).
    (7) [Reserved]. For further guidance, see Sec. 1.1502-32T(h)(7).

[T.D. 8560, 59 FR 41685, Aug. 15, 1994, as amended by T.D. 8677, 61 FR 
33323, June 27, 1996; T.D. 8560, 62 FR 12098, Mar. 14, 1997; T.D. 8823, 
64 FR 36099, July 2, 1999; T.D. 8984, 67 FR 11040, Mar. 12, 2002; T.D. 
9048, 68 FR 12291, Mar. 14, 2003; T.D. 9089, 68 FR 52495, Sept. 4, 2003]