[Code of Federal Regulations]
[Title 26, Volume 7]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.537-1]

[Page 249-253]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.537-1  Reasonable needs of the business.

    (a) In general. The term reasonable needs of the business includes 
(1) the reasonably anticipated needs of the business (including product 
liability loss reserves, as defined in paragraph (f) of this section), 
(2) the section 303 redemption needs of the business, as defined in 
paragraph (c) of this section, and (3) the excess business holdings 
redemption needs of the business as described in paragraph (d) of this 
section. See paragraph (e) of this section for additional rules relating 
to the section 303 redemption needs and the excess business holdings 
redemption needs of the business. An accumulation of the earnings and 
profits (including the undistributed earnings and profits of prior 
years) is in excess of the reasonable needs of the business if it 
exceeds the amount that a prudent businessman would consider appropriate 
for the present business purposes and for the reasonably anticipated 
future needs of the business. The need to retain earnings and profits 
must be directly connected with the needs of thecorporation itself and 
must be for bona fide business purposes. For purposes of this paragraph 
the section 303 redemption needs of the business and the excess business 
holdings redemption needs of the business are deemed to be directly 
connected with the needs

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of the business and for a bona fide business purpose. See Sec. 1.537-3 
for a discussion of what constitutes the business of the corporation. 
The extent to which earnings and profits have been distributed by the 
corporation may be taken into account in determining whether or not 
retained earnings and profits exceed the reasonable needs of the 
business. See Sec. 1.537-2, relating to grounds for accumulation of 
earnings and profits.
    (b) Reasonable anticipated needs. (1) In order for a corporation to 
justify an accumulation of earnings and profits for reasonably 
anticipated future needs, there must be an indication that the future 
needs of the business require such accumulation, and the corporation 
must have specific, definite, and feasible plans for the use of such 
accumulation. Such an accumulation need not be used immediately, nor 
must the plans for its use be consummated within a short period after 
the close of the taxable year, provided that such accumulation will be 
used within a reasonable time depending upon all the facts and 
circumstances relating to the future needs of the business. Where the 
future needs of the business are uncertain or vague, where the plans for 
the future use of an accumulation are not specific, definite, and 
feasible, or where the execution of such a plan is postponed 
indefinitely, an accumulation cannot be justified on the grounds of 
reasonably anticipated needs of the business.
    (2) Consideration shall be given to reasonably anticipated needs as 
they exist on the basis of the facts at the close of the taxable year. 
Thus, subsequent events shall not be used for the purpose of showing 
that the retention of earnings or profits was unreasonable at the close 
of the taxable year if all the elements of reasonable anticipation are 
present at the close of such taxable year. However, subsequent events 
may be considered to determine whether the taxpayer actually intended to 
consummate or has actually consummated the plans for which the earnings 
and profits were accumulated. In this connection, projected expansion or 
investment plans shall be reviewed in the light of the facts during each 
year and as they exist as of the close of the taxable year. If a 
corporation has justified an accumulation for future needs by plans 
never consummated, the amount of such an accumulation shall be taken 
into account in determining the reasonableness of subsequent 
accumulations.
    (c) Section 303 redemption needs of the business. (1) The term 
section 303 redemption needs means, with respect to the taxable year of 
the corporation in which a shareholder of the corporation died or any 
taxable year thereafter, the amount needed (or reasonably anticipated to 
be needed) to redeem stock included in the gross estate of such 
shareholder but not in excess of the amount necessary to effect a 
distribution to which section 303 applies. For purposes of this 
paragraph, the term shareholder includes an individual in whose gross 
estate stock of the corporation is includable upon his death for Federal 
estate tax purposes.
    (2) This paragraph applies to a corporation to which section 303(c) 
would apply if a distribution described therein were made.
    (3) If stock included in the gross estate of a decedent is stock of 
two or more corporations described in section 303(b)(2)(B), the amount 
needed by each such corporation for section 303 redemption purposes 
under this section shall, unless the particular facts and circumstances 
indicate otherwise, be that amount which bears the same ratio to the 
amount described in section 303(a) as the fair market value of such 
corporation's stock included in the gross estate of such decedent bears 
to the fair market value of all of the stock of such corporations 
included in the gross estate. For example, facts and circumstances 
indicating that the allocation prescribed by this subparagraph is not 
required would include notice given to the corporations by the executor 
or administrator of the decedent's estate that he intends to request the 
redemption of stock of only one of such corporations or the redemption 
of stock of such corporations in a ratio which is unrelated to the 
respective fair market values of the stock of the corporations included 
in the decedent's gross estate.

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    (4) The provisions of this paragraph apply only to taxable years 
ending after May 26, 1969.
    (d) Excess business holdings redemption needs. (1) The term excess 
business holdings redemption needs means, with respect to taxable years 
of the corporation ending after May 26, 1969, the amount needed (or 
reasonably anticipated to be needed) to redeem from a private foundation 
stock which:
    (i) Such foundation held on May 26, 1969 (or which was received by 
such foundation pursuant to a will or irrevocable trust to which section 
4943(c)(5) applies), and either
    (ii) Constituted excess business holdings on such date or would have 
constituted excess business holdings as of that date if there were taken 
into account (a) stock received pursuant to a will or trust described in 
subdivision (i) of this subparagraph and (b) the reduction in the total 
outstanding stock of the corporation which would have resulted solely 
from the redemption of stock held by the private foundation, or
    (iii) Constituted stock redemption of which before January 1, 1975, 
or after October 4, 1976, and before January 1, 1977, is, by reason of 
section 101(l)(2)(B) of the Tax Reform Act of 1969, as amended by 
section 1309 of the Tax Reform Act of 1976, and Sec. 53.4941(d)-4(b), 
permitted without imposition of tax under section 4941, but only to the 
extent such stock is to be redeemed before January 1, 1975 or after 
October 4, 1976, and before January 1, 1977, or is to be redeemed 
thereafter pursuant to the terms of a binding contract entered into on 
or before such date to redeem all of the stock of the corporation held 
by the private foundation on such date.
    (2) The purpose of subparagraph (1) of this paragraph is to 
facilitate a private-foundation's disposition of certain excess business 
holdings, in order for the private foundation not to be liable for tax 
under section 4943. See section 4943(c) and the regulations thereunder 
for the definition of excess business holdings. For purposes of section 
537(b)(2) and this paragraph, however, any determination of the 
existence of excess business holdings shall be made without taking into 
account the provisions of section 4943(c)(4) which treat certain excess 
business holdings as held by a disqualified person (rather than by the 
private foundation), except that the periods described in section 
4943(c)(4) (B), (C), and (D), if applicable, shall be taken into account 
in determining the period during which an excess business holdings 
redemption need may be deemed to exist. Thus, an excess business 
holdings redemption need may, depending upon the facts and 
circumstances, be deemed to exist for a part or all of the 20-year, 15-
year, or 10-year period specified in section 4943(c)(4)(B) during which 
the interest in the corporation held by the private foundation is 
treated as held by a disqualified person rather than by the private 
foundation, and, if applicable, (i) any suspension of such 20-year, 15-
year, or 10-year period as provided by section 4943(c)(4)(C) and (ii) 
the 15-year second phase specified in section 4943(c)(4)(D). The 
foregoing sentence is not to be construed to prevent an accumulation of 
earnings and profits for the purpose of effecting a redemption of excess 
business holdings at a time or times prior to expiration of the periods 
described in such sentence. This subparagraph is not to be construed to 
prevent an accumulation of earnings and profits for the purpose of 
effecting a redemption described in subdivision (iii) of subparagraph 
(1) of this paragraph.
    (3) The extent of an excess business holdings redemption need cannot 
exceed the total number of shares of stock so held or received by the 
private foundation (i) redemption of which alone would sufficiently 
reduce such private foundation's proportionate share of the 
corporation's total outstanding stock in order for the private 
foundation not to be liable for tax under section 4943, or (ii) 
redemption of which is, by reason of Sec. 53.4941(d)-4(b), permitted 
without imposition of tax under section 4941 provided that such 
redemption is accomplished within the period and in the manner 
prescribed in subdivision (iii) of subparagraph (1) of this paragraph. 
Thus, excess business holdings of a private foundation attributable to 
an increase in the private foundation's proportionate share of the 
corporation's total outstanding stock by reason of a redemption of stock 
after May 26, 1969, from any person

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other than the private foundation do not give rise to an excess business 
holdings redemption need.
    (4) For purposes of subdivision (ii) of subparagraph (1) of this 
paragraph, an excess business holdings redemption need can arise with 
respect to shares of the corporation's stock under section 537(a)(3) 
only following actual acquisition by the private foundation of such 
shares and their characterization as an excess business holding. Thus, 
this paragraph does not apply to an accumulation of earnings and profits 
in one taxable year in anticipation of redemption of excess business 
holdings to be acquired by a private foundation in a subsequent year 
pursuant to a will or irrevocable trust to which section 4943(c)(5) 
applies or in anticipation of shares held becoming excess business 
holdings of the private foundation in a subsequent year by reason of 
additional shares to be received by the private foundation in such 
subsequent year pursuant to a will or irrevocable trust to which section 
4943(c)(5) applies. Once having arisen, however, an excess business 
holdings redemption need may continue until redemption of the private 
foundation's excess business holdings described in this paragraph or 
other disposition of such excess business holdings by the private 
foundation.
    (5) Notwithstanding any other provision of this paragraph, an excess 
business holdings redemption need will not be deemed to exist with 
respect to stock held by a private foundation the redemption of which 
would subject any person to tax under section 4941.
    (6) For purposes of subdivision (ii) of subparagraph (1) of this 
paragraph, the number of shares of stock held by a private foundation on 
May 26, 1969 (or received pursuant to a will or irrevocable trust to 
which section 4943(c)(5) applies), redemption of which alone would 
sufficiently reduce such foundation's proportionate share of a 
corporation's total outstanding stock in order for the foundation not to 
be liable for tax under section 4943 may be determined by application of 
the following formula:
[GRAPHIC] [TIFF OMITTED] TC14NO91.159

X=Number of shares to be redeemed.
Y=Maximum percentage of outstanding stock which private foundation can 
hold without being liable for tax under section 4943.
PH=Number of shares of stock held by private foundation on May 26, 1969, 
or received pursuant to a will or irrevocable trust to which section 
4943(c)(5) applies.
SO=Total number of shares of stock outstanding unreduced by any 
redemption from a person other than the private foundation.

    (7) The provisions of this paragraph may be illustrated by the 
following example:

    Example. (i) On May 26, 1969, Private Foundation A holds 60 of the 
100 outstanding shares of the capital stock of corporation X, which is 
not a disqualified person with respect to A. None of the remaining 40 
shares is owned by a disqualified person within the meaning of section 
4946(a). On June 1, 1975, X redeems 10 shares of its stock from 
individual B, thus reducing its outstanding stock to 90 shares. On June 
1, 1976, A receives 20 additional shares of X stock by bequest under a 
will to which section 4943(c)(5) applies. As of June 1, 1976, then, A 
holds 80 of the 90 outstanding shares of X. Solely for purposes of this 
example and to illustrate the application of this paragraph, it will be 
assumed that in order not to be liable for the initial tax under section 
4943, A must, before the close of the second phase described in section 
4943(c)(4)(D), reduce its proportionate stock interest in X to 35 
percent. A requests X to redeem from it a sufficient number of its 
shares to so reduce its proportionate stock interest in X to 35 percent, 
and X agrees to effect such a redemption.
    (ii) As of May 26, 1969, A's excess business holdings are 25 shares 
of X, the number of shares which A would be required to dispose of to a 
person other than X in order to reduce its proportionate holdings in X 
to no more than 35percent. If the disposition is to be by means of a 
redemption, however, A's excess business holdings on May 26, 1969, for 
purposes of determining X's excess business holdings redemption needs, 
are 39 shares, i.e., the number of shares X would be required to redeem 
in order to reduce A's proportionate stock interest to 35 percent. 
Although the redemption of 10 shares from B on June 1, 1975, creates 
additional excess business holdings of A because it effectively 
increases A's proportionate stock interest in X, this increase does not 
create an additional excess business holdings redemption need because it 
resulted from a redemption from a

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person other than A. The bequest of 20 shares of X received by A on June 
1, 1976, creates a further excess business holdings redemption need as 
of that date in the amount needed (or reasonably anticipated to be 
needed) to redeem an additional 31 shares from A, i.e., the number of 
shares which, when added to the excess business holdings of A on May 26, 
1969, would have to be redeemed to reduce A's proportionate stock 
interest in X to 35 percent without taking the earlier redemption from B 
into account.

    (e)(1) A determination whether and to what extent an amount is 
needed (or reasonably anticipated to be needed) for the purpose 
described in subparagraph (1) of paragraph (c) or (d) of this section is 
dependent upon the particular circumstances of the case, including the 
total amount of earnings and profits accumulated in prior years which 
may be available for such purpose and the existence of a reasonable 
expectation that a redemption described in paragraph (c) or (d) of this 
section will in fact be effected. Although paragraph (c) or (d) of this 
section may apply even though no redemption of stock is in fact 
effected, the failure to effect such redemption may be taken into 
account in determining whether the accumulation was needed (or 
reasonably anticipated to be needed) for a purpose described in 
paragraph (c) or (d).
    (2) In applying subparagraph (1) of paragraph (c) or (d) of this 
section, the discharge of an obligation incurred to make a redemption 
shall be treated as the making of the redemption.
    (3) In determining whether an accumulation is in excess of the 
reasonable needs of the business for a particular year, the fact that 
one of the exceptions specified in paragraph (c) or (d) of this section 
applies in a subsequent year is not to give rise to an inference that 
the accumulation would not have been for the reasonable needs of the 
business in the prior year. Also, no inference is to be drawn from the 
enactment of section 537(a) (2) and (3) that accumulations in any prior 
year would not have been for the reasonable needs of the business in the 
absence of such provisions. Thus, the reasonableness of accumulations in 
years prior to a year in which one of the exceptions specified in 
paragraph (c) or (d) of this section applies is to be determined solely 
upon the facts and circumstances existing at the times the accumulations 
occur.
    (f) Product liability loss reserves. (1) The term product liability 
loss reserve means, with respect to taxable years beginning after 
September 30, 1979, reasonable amounts accumulated for the payment of 
reasonably anticipated product liability losses, as defined in section 
172(j) and Sec. 1.172-13(b)(1).
    (2) For purposes of this paragraph, whether an accumulation for 
anticipated product liability losses is reasonable in amount and whether 
such anticipated product liability losses are likely to occur shall be 
determined in light of all facts and circumstances of the taxpayer 
making such accumulation. Some of the factors to be considered in 
determining the reasonableness of the accumulation include the 
taxpayer's previous product liability experience, the extent of the 
taxpayer's coverage by commercial product liability insurance, the 
income tax consequences of the taxpayer's ability to deduct product 
liability losses and related expenses, and the taxpayer's potential 
future liability due to defective products in light of the taxpayer's 
plans to expand the production of products currently being manufactured, 
provided such plans are specific, definite and feasible. Additionally, a 
factor to be considered in determining whether the accumulation is 
reasonable in amount is whether the taxpayer, in accounting for its 
potential future liability, took into account the reasonably estimated 
present value of the potential future liability.
    (3) Only those accumulations made with respect to products that have 
been manufactured, leased, or sold shall be considered as accumulations 
made under this paragraph. Thus, for example, accumulations with respect 
to a product which has not progressed beyond the development stage are 
not reasonable accumulations under this paragraph.

[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7165, 37 FR 
5022, Mar. 9, 1972, 37 FR 5703, Mar. 18, 1972; T.D. 7678, 44 FR 12416, 
Feb. 26, 1980; T.D. 8096, 51 FR 30483, Aug. 27, 1986]

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