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CFR Citation: 26 CFR Part 1

RIN ID: RIN 1545-AW71

TD ID: [TD 8913]

NOTICE: RULES

ACTION: Income taxes:

DOCUMENT ACTION: Final regulations.

SUBJECT CATEGORY: Guidance Under Section 355(d); Recognition of Gain on Certain Distributions of Stock or Securities

DATES: Effective Date: These regulations are effective December 20, 2000.

Applicability Date: These regulations apply to distributions occurring after December 20, 2000, except they do not apply to distributions occurring pursuant to a written agreement which is (subject to customary conditions) binding on December 20, 2000, and at all times thereafter.

DOCUMENT SUMMARY: This document contains final regulations relating to recognition of gain on certain distributions of stock or securities of a controlled corporation. These final regulations affect corporations and their shareholders. These regulations reflect the enactment of section 355(d) of the Internal Revenue Code by the Omnibus Budget Reconciliation Act of 1990.

SUMMARY: Recognition of gain on stock or securities distribution,

SUPPLEMENTAL INFORMATION

On May 3, 1999, the IRS and Treasury issued a notice of proposed rulemaking (REG10600498) in the Federal Register (64 FR 23554) setting forth rules under section 355(d) of the Internal Revenue Code relating to the recognition of gain on certain distributions of stock or securities of a controlled corporation. Generally, section 355(d) requires recognition of gain on a distribution of stock or securities of a controlled corporation (Controlled) (as though the Controlled stock or securities were sold to the distributee at its fair market value) if, immediately after the distribution, any person holds disqualified stock of the distributing corporation (Distributing) or of any distributed Controlled that constitutes a 50 percent or greater interest. Disqualified stock is stock in Distributing acquired by purchase after October 9, 1990, and during the fiveyear period (taking into account section 355(d)(6)) ending on the date of distribution (the fiveyear period), or Controlled stock either (1) acquired by purchase during the fiveyear period or (2) distributed with respect to either disqualified Distributing stock or on Distributing securities acquired by purchase during the fiveyear period. No public hearing regarding these proposed regulations was held. Written comments to the notice were received. After consideration of all the comments, the proposed regulations are adopted as revised by this Treasury decision. The principal revisions are discussed below.
Explanation of Revisions and Summary of Comments

1. Purposes of Section 355(d) Not Violated

Generally, Congress intended section 355(d) to prevent taxpayers from using section 355 to dispose of subsidiaries in salelike transactions, or to obtain a fair market value steppedup basis for future dispositions, without incurring a corporate level tax. See H.R. Rep 101881, at 341 (1990). Under proposed Sec. 1.3556(b)(3), section 355(d) does not apply to a distribution that does not violate its purposes (the purpose exception). As proposed, the purpose exception applies if the effect of the distribution and any related transaction is that a disqualified person neither increases an interest in Distributing or Controlled nor obtains a purchased basis in Controlled stock. A disqualified person is any person that, immediately after a distribution, holds disqualified stock in Distributing or Controlled that constitutes a 50 percent or greater interest (under section 355(d)(4) and proposed Sec. 1.3556(c)). The proposed regulations define purchased basis as basis in Controlled stock that is disqualified stock, unless the Controlled stock and the Distributing stock on which the Controlled stock is distributed are treated as acquired by purchase solely under the attribution rules of section 355(d)(8) and proposed Sec. 1.3556(e)(1). Commentators have expressed concern that certain distributions of stock may technically constitute disqualified distributions under the proposed regulations, yet do not appear to violate the purposes of section 355(d). Section 1.3556(b)(3) has
[[Page 79720]]
been expanded and clarified in the final regulations to prevent the application of section 355(d) in the case of certain transactions that do not violate its purposes. (Under the final regulations, certain references to stock include securities.) The revisions are explained below.

a. Technical Clarification of Disqualified Person

The definition of ``disqualified person'' in the proposed regulations could be read to include persons who hold disqualified stock in Distributing or Controlled but who did not directly or indirectly purchase that stock. This could result in certain distributions that should not violate the purposes of section 355(d) nevertheless being disqualified distributions. The final regulations clarify that the term ``disqualified person'' includes only a person that meets that definition because of its own purchase of
``disqualified stock'' (or who receives stock in Controlled with respect to stock that the person purchased).

b. Related Transactions

Commentators suggested that some ``related acquisitions'' of stock in Distributing or Controlled prior to or following a distribution should not be taken into account in determining if the purpose rule applies. The IRS and Treasury agree that in many cases a related acquisition that increases a disqualified person's interest in Distributing or Controlled should not be taken into account. In addition, the IRS and Treasury are concerned that the proposed regulations could be interpreted to allow taxpayers, by relying on certain other related transactions, to avoid section 355(d) inappropriately, where a distribution of stock, if viewed
independently, would constitute a disqualified distribution. For example, where a distribution of Controlled stock to a Distributing shareholder constitutes a disqualified distribution, a subsequent but related distribution of that stock should not have the effect of ``cleansing'' the prior disqualified distribution. Based on these concerns, and a belief that other provisions of the final regulations will adequately address the effect of related transactions (e.g., the antiavoidance provision, Sec. 1.3556(b)(4)), the final regulations remove the reference to related transactions in the purpose rule. c. Fractional Shares

Some commentators requested that de minimis increases in interest in the stock of Distributing or Controlled should be disregarded in determining whether the purpose rule applies. The final regulations provide that an issuance of cash in lieu of fractional shares is disregarded in applying the purpose exception.

2. Disqualified Stock

Generally, under the proposed regulations, disqualified stock is any stock in Distributing or Controlled acquired by purchase during the fiveyear period and any Controlled stock received in a distribution to the extent attributable to distributions on any stock in Distributing acquired by purchase during the fiveyear period. The definition of disqualified stock has been modified in the final regulations. The final regulations provide that stock of Distributing or Controlled that is acquired by a purchase within the fiveyear period (including such stock treated as indirectly acquired by purchase under section 355(d)(8) or Sec. 1.3556(e)(1), (2), (3) or (4) of the final regulations) ceases to be acquired by that purchase if the basis resulting from the purchase is eliminated. Basis in the stock of a corporation (or in an interest in another entity) is eliminated if (and when) it would no longer be taken into account by any person in determining gain or loss on a sale or exchange of any stock of such corporation (or an interest in the other entity). Basis is not eliminated, however, if it is allocated between stock of two corporations under Sec. 1.3582(a).

For example, under the proposed regulations, a direct purchase by Distributing of all of the stock in Controlled, followed by a distribution of the Controlled corporation stock is a disqualified distribution. Under the final regulations, because the distribution of Controlled will result in an elimination of the basis that resulted from Distributing's purchase of Controlled stock, the Controlled stock would no longer be treated as purchased. The Controlled stock is therefore not disqualified stock and the distribution of Controlled would not be a disqualified distribution. Further, any purchases of stock of lower tier subsidiaries of Controlled that arise under section 355(d)(8) as a result of Distributing's purchase of Controlled also would cease to be treated as purchased when Distributing's basis in Controlled is eliminated. Thus, in the example above, if Controlled has a subsidiary that would have been deemed purchased by Distributing when Distributing purchased the Controlled stock, the stock of that subsidiary would cease to be treated as purchased when Distributing's basis in Controlled is eliminated.

In general, basis of stock resulting from a purchase also is treated as eliminated if such stock is transferred to another person in an exchange or other transfer to which Sec. 1.3556(e)(2) or (3) (relating to carryover basis and exchange basis transactions) applies. The elimination of basis as a result of the transfer, however, does not affect the deemed purchase under Sec. 1.3556(e)(2) or (3) that arises as a result of the transfer. Thus, for example, if A purchases Controlled stock and subsequently transfers that stock to Distributing in a reorganization qualifying under section 368(a)(1)(B) in exchange for Distributing stock, A's basis in Controlled is eliminated. Under Sec. 1.3556(e)(3), A is deemed to purchase the Distributing stock on the date A purchased the Controlled stock. The elimination of A's basis in Controlled does not affect A's deemed purchase of its stock in Distributing (i.e., A's exchanged basis in its Distributing stock resulting from its deemed purchase of that stock is not eliminated). Also, Distributing is deemed under Sec. 1.3556(e)(2) to have purchased the Controlled stock on the date A purchased the Controlled stock. The elimination of A's basis in Controlled does not affect the deemed purchase by Distributing of the Controlled stock (i.e., Distributing's carryover basis in its Controlled stock resulting from its deemed purchase of that stock is not eliminated).

Under section 355(d)(3)(b)(ii) and Sec. 1.3556(b)(2)(i)(B)(2), disqualified stock includes Controlled stock received in exchange for Distributing stock acquired by purchase. In a splitoff or splitup, the distributee shareholder will exchange its stock in Distributing for Controlled stock in an exchange described in Sec. 1.3556(e)(3). Technically, under the basis elimination rule, this would cause the Distributing stock held by such shareholder to no longer be treated as ``acquired by purchase'' at the time of the distribution. As a result, the distributed Controlled stock would not be received in exchange for Distributing stock ``acquired by purchase,'' and thus, would not be disqualified stock. In order to prevent this result, Sec. 1.355 (6)(b)(2)(iii)(B)(3) provides that basis resulting from a purchase of Distributing stock that is exchanged for Controlled stock is not eliminated notwithstanding that Sec. 1.3556(e)(3) applies to the exchange.

The modified definition of disqualified stock eliminates the need for the ``purchased interest no longer held'' rule of Sec. 1.355 6(b)(3)(iv) of the proposed regulations, since transactions that result in the purchased interest no
[[Page 79721]]
longer being held also will result in an elimination of basis. Accordingly, that paragraph has been deleted. Examples have been added illustrating the effect of the changes discussed.

3. Purchase

Section 355(d)(5) provides that, with certain exceptions, a purchase means any acquisition, but only if (1) the basis of the property acquired in the hands of the acquirer is not determined in whole or in part by reference to the adjusted basis of such property in the hands of the person from whom acquired, or under section 1014(a), and (2) the property is not acquired in an exchange to which section 351, 354, 355 or 356 applies. The proposed regulations follow the statutory definition of a purchase and provide examples of both purchase and nonpurchase acquisitions. See Sec. 1.3556(d).

a. Section 338

An example in the proposed regulations illustrates that if a section 338 election is made pursuant to an acquisition of stock, the stock acquired is treated as purchased for purposes of section 355(d)(5)(A) (See Sec. 1.3556(d)(1)(iii) Example 2). The example further illustrates that any stock held by the acquired target (and deemed sold to new target) also is purchased stock. The final regulations provide that stock acquired in a qualified stock purchase with respect to which a section 338 election (or a section 338(h)(10) election) is made is not treated as purchased for purposes of section 355(d)(5)(A). However, the final regulations retain the rule that any stock held by old target that is treated as purchased by new target is treated as acquired by purchase for purposes of section 355(d)(5)(A) (unless a section 338 election or 338(h)(10) election also is made with respect to that purchase).

b. Partnerships

Section 1.3556(d)(2)(v)(A) of the final regulations clarifies that an acquisition of stock (or an interest in another entity) by a partner pursuant to the liquidation of a partnership interest is a purchase of the stock (or other interest) acquired at the time of the liquidation of the partnership. Under Sec. 1.3556(d)(2)(v)(B) of the final regulations, if the adjusted basis of stock (or an interest in another entity) held by a partnership is increased under section 734(b), a proportionate amount of the stock (or other interest) will be treated as purchased at the time of the basis adjustment. The amount purchased is determined by reference to the amount of the basis adjustment over the fair market value of the stock (or other interest) at the time of the adjustment.
c. Transfers of Cash, Cash Items, Marketable Stock and Debt of the Transferor

i. Transferred With Respect to an Active Trade or Business. Under section 355(d)(5)(B), a purchase includes any acquisition of property in an exchange to which section 351 applies to the extent the property is acquired in exchange for any cash or cash item, any marketable stock or security, or any debt of the transferor. The proposed regulations provide certain exceptions to purchase treatment under section 355(d)(5)(B). An acquisition of stock in exchange for any cash or cash item, marketable stock or debt of the transferor in a section 351 transaction generally is not a purchase if the transferor transfers the items as part of an active trade or business and the transferred items do not exceed the reasonable needs of the trade or business (the active business exception). See Sec. 1.3556(d)(3)(iv). The proposed regulations require, in part, that the transferee continue the active conduct of the trade or business. Commentators have expressed concern that this requirement would prevent a retransfer of the assets to a lower tier corporation within the same affiliated group. In Sec. 1.355 6(d)(3)(iv)(4)(E), the final regulations clarify that a transfer of assets does not fail to meet the active business exception solely because the transferee transfers the assets to another member of the transferee's affiliated group if the requirements for the active business exception in Sec. 1.3556(d)(3)(iv)(A)(1), (2), (3) and (4) would be met it the transferor had transferred the assets directly to the final transferee.

ii. Transfers Between Members of the Same Affiliated Group. Under the proposed regulations, an acquisition of stock in exchange for any cash or cash item, marketable stock or security, or debt of the transferor in a section 351 transaction is generally not a purchase if the transferor corporation or corporations, the transferee corporation (whether formed in the transaction or already existing), and any distributed controlled corporation of the transferee corporation are members of the same affiliated group as defined in section 1504(a) before the section 351 transaction (if the transferee corporation is in existence before the transaction). See Sec. 1.3556(d)(3)(v) for additional requirements. The final regulations clarify that the cash or cash item, marketable stock or security, or debt of the transferor that is transferred must not have been acquired from a nonmember in a related transaction in which section 362(a) or (b) applies to determine the basis in the acquired assets. Examples in the final regulations have been modified to reflect this clarification. See Sec. 1.355 6(d)(4)(iii) and (d)(5)(iii) illustrating the effects of a forward and reverse triangular merger, respectively. The final regulations also eliminate the requirement that distributed controlled corporations be a member of the group before the section 351 transaction.

iii. Certain Section 355 and Section 305 Distributions. Under Sec. 1.3556(d)(1)(i)(B) of the proposed regulations, stock acquired in a distribution to which section 355 applies, whether in exchange for stock or pro rata, is not a purchase within the meaning of section 355(d). The final regulations in Sec. 1.3556(e)(4) modify this rule to provide that if a distributing corporation distributes any stock of a controlled corporation with respect to recently purchased distributing stock in a distribution that qualifies under section 355, the stock is deemed to be acquired by purchase by the distributee on the date the distributee acquired the recently purchased distributing stock. For this purpose, recently purchased distributing stock is stock in the distributing corporation acquired by purchase (determined without regard to the attribution rules of section 355(d)(8) and Sec. 1.355 6(e)(1)) by the distributee during the fiveyear period with respect to that distribution. A similar rule is added with respect to distributions of stock under section 305(a) to the extent section 307(a) applies to determine the recipient's basis.
4. Whether a Person Holds a 50 Percent or Greater Interest

a. Exchanged Basis Rule and Plan or Arrangement

Section 1.3556(c) of the proposed regulations provides rules for determining if a person holds a 50 percent or greater interest in Distributing or Controlled. Under section 355(d)(7)(B) and Sec. 1.355 6(c)(4), if two or more persons act pursuant to a plan or arrangement with respect to acquisitions of stock or securities in Distributing or Controlled, those persons are treated as one person for purposes of section 355(d). A rule has been added to the final regulations clarifying the application of this rule in the context of an exchanged basis transaction with respect to purchased stock. If two or more persons do not act pursuant to a plan or arrangement with respect to an acquisition of stock in a corporation (the first corporation), a [[Page 79722]]
subsequent exchange basis acquisition will not result in such persons being treated as one person, even if the acquisition of the second corporation's stock is pursuant to a plan or arrangement. An example has been added illustrating the effect of this rule.

b. Options

Section 1.3556(c)(3) of the proposed and final regulations generally provides that options outstanding when the distribution occurs are treated as exercised when issued or last transferred if two criteria are met. First, the deemed exercise would cause a person to be a disqualified person. Second, immediately after the distribution, taking into account all the facts and circumstances, it is reasonably certain the option will be exercised. Commentators suggested that the ``reasonably certain to be exercised'' test be replaced with a ``principal purpose to avoid section 355(d)'' standard patterned on the regulations under section 382. The IRS and Treasury continue to believe, however, that the more objective standard of the proposed regulations is appropriate.

In response to a comment, the final regulations exclude from the definition of options cash settlement options, phantom stock, stock appreciation rights, and national principal contracts. However, to the extent that such instruments are exercisable into stock, they still would be subject to the deemed exercise rule of the final regulations under Sec. 1.3556(c)(3)(v) as an ``other instrument that provides for the right to purchase, issue, redeem, or transfer stock.'' The final regulations have also added a rule for substituted options treating the substituted option as issued on the date the original option was issued.

5. Statistical Sampling

Under Sec. 1.3556(f)(1) of the proposed regulations, a distributing corporation must determine whether a disqualified person holds its stock or the stock of any distributed controlled corporation. Under Sec. 1.3556(f)(4), a distributing corporation may, absent actual knowledge with regard to a particular shareholder, presume that no lessthanfivepercent shareholder of a corporation acquired stock or securities by purchase during the fiveyear period. In Sec. 1.355 6(f)(5) Example 3, the final regulations clarify that application of statistical sampling procedures to estimate the basis of shares acquired in certain reorganizations does not have the effect of giving actual knowledge of a purchase of stock beyond the sample group. 6. Administrative Remedies

A comment urged the adoption of various forms of administrative relief from the recognition of gain in a disqualified distribution. The suggested forms of relief included the issuance of private letter rulings granting tax free treatment in appropriate cases, gain recognition agreements, stock basis waivers, or some combination of the above. Section 355(d) applies at a specific time (at the time of the disqualified distribution) and requires Distributing to recognize gain as if it had sold Controlled at its fair market value at that time. Accordingly, the IRS and Treasury Department do not believe that it would be appropriate to adopt any of these administrative relief provisions. Basis reduction or gain recognition agreements could result in either a complete avoidance or a deferral of gain recognition. Moreover, the IRS and Treasury do not believe that granting exceptions to section 355(d) by private letter ruling is appropriate. However, the final regulations include a new provision stating that the Commissioner may provide by guidance published in the Internal Revenue Bulletin that other distributions are not disqualified distributions because they do not violate the purposes of section 355(d).

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

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

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows: PART 1INCOME TAXES

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

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

Section 1.3556 also issued under 26 U.S.C. 355(d)(9). * * *

Par. 2. Section 1.3550 is amended by revising the section heading, adding introductory text, removing the existing entry for Sec. 1.3556, and adding new entries for Sec. 1.3556 to read as follows:

Sec. 1.3550 Table of contents.

To facilitate the use of Secs. 1.3551 through 1.3556, this section lists the following major paragraphs in those sections: * * * * *
Sec. 1.3556 Recognition of gain on certain distributions of stock or securities in controlled corporation.
(a) Conventions.
(1) Examples.
(2) Fiveyear period.
(3) Distributing securities.
(4) Marketable securities.
(b) General rules and purposes of section 355(d).
(1) Disqualified distributions in general.
(2) Disqualified stock.
(i) In general.
(ii) Purchase.
(iii) Exceptions.
(A) Purchase eliminated.
(B) Deemed purchase eliminated.
(C) Elimination of basis.
(1) General rule.
(2) Special rule for transferred and exchanged basis property. (3) Special rule for Splitoffs and Splitups.
(D) Special rule if basis allocated between two corporations. (3) Certain distributions not disqualified distributions because purposes of section 355(d) not violated.
(i) In general.
(ii) Disqualified person.
(iii) Purchased basis.
(iv) Increase in interest because payment of cash in lieu of fractional shares.
(v) Other exceptions.
(vi) Examples.
(4) Antiavoidance rule.
(i) In general.
(ii) Example.
(c) Whether a person holds a 50 percent or greater interest. (1) In general.
(2) Valuation.
(3) Effect of options, warrants, convertible obligations, and other similar interests.
(i) Application.
(ii) General rule.
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(iii) Options deemed newly issued and substituted options. (A) Exchange, adjustment, or alteration of existing option. (B) Certain compensatory options.
(C) Substituted options.
(iv) Effect of treating an option as exercised.
(A) In general.
(B) Stock purchase agreement or similar arrangement.
(v) Instruments treated as options.
(vi) Instruments generally not treated as options.
(A) Escrow, pledge, or other security agreements.
(B) Compensatory options.
(1) General rule.
(2) Exception.
(C) Certain stock conversion features.
(D) Options exercisable only upon death, disability, mental imcompetency, or separation from service.
(E) Rights of first refusal.
(F) Other enumerated instruments.
(vii) Reasonably certain that the option will be exercised. (A) In general.
(B) Stock purchase agreement or similar arrangement.
(viii) Examples.
(4) Plan or arrangement.
(i) In general.
(ii) Understanding.
(iii) Examples.
(iv) Exception.
(A) Subsequent disposition.
(B) Example.
(d) Purchase.
(1) In general.
(i) Definition of purchase under section 355(d)(5)(A).
(ii) Section 355 distributions.
(iii) Example.
(2) Exceptions to definition of purchase under section 355(d)(5)(A).
(i) Acquisition of stock in a transaction which includes other property or money.
(A) Transferors and shareholders of transferor or distributing corporations.
(1) In general.
(2) Exception.
(B) Transferee corporations.
(1) In general.
(2) Exception.
(C) Examples.
(ii) Acquisition of stock in a distribution to which section 305(a) applies.
(iii) Section 1036(a) exchange.
(iv) Section 338 elections.
(A) In general.
(B) Example.
(v) Partnership distributions.
(A) Section 732(b).
(B) Section 734(b).
(3) Certain section 351 exchanges treated as purchases. (i) In general.
(A) Treatment of stock received by transferor.
(B) Multiple classes of stock.
(ii) Cash item, marketable stock.
(iii) Exception for certain acquisitions.
(A) In general.
(B) Example.
(iv) Exception for assets transferred as part of an active trade or business.
(A) In general.
(B) Active conduct of a trade or business.
(C) Reasonable needs of the trade or business.
(D) Consideration of all facts and circumstances.
(E) Successive transfers.
(v) Exception for transfer between members of the same affiliated group.
(A) In general.
(B) Examples.
(4) Triangular asset reorganizations.
(i) Definition.
(ii) Treatment.
(iii) Example.
(5) Reverse triangular reorganizations other than triangular asset reorganizations.
(i) In general.
(ii) Letter ruling and closing agreement.
(iii) Example.
(6) Treatment of group structure changes.
(i) In general.
(ii) Adjustments to basis of highertier members.
(iii) Example.
(7) Special rules for triangular asset reorganizations, other reverse triangular reorganizations, and group structure changes. (e) Deemed purchase and timing rules.
(1) Attribution and aggregation.
(i) In general.
(ii) Purchase of additional interest.
(iii) Purchase between persons treated as one person.
(iv) Purchase by a person already treated as holding stock under section 355(d)(8)(A).
(v) Examples.
(2) Transferred basis rule.
(3) Exchanged basis rule.
(i) In general.
(ii) Example.
(4) Certain section 355 or section 305 distributions.
(i) Section 355.
(ii) Section 305.
(5) Substantial diminution of risk.
(i) In general.
(ii) Property to which suspension applies.
(iii) Risk of loss substantially diminished.
(iv) Special class of stock.
(f) Duty to determine stockholders.
(1) In general.
(2) Deemed knowledge of contents of securities filings. (3) Presumptions as to securities filings.
(4) Presumption as to lessthanfivepercent shareholders. (5) Examples.

(g) Effective date.

Par. 3. Section 1.3556 is revised to read as follows: Sec. 1.3556 Recognition of gain on certain distributions of stock or securities in controlled corporation.
(a) Conventions(1) Examples. For purposes of the examples in this section, unless otherwise stated, assume that P, S, T, X, Y, N, HC, D, D1, D2, D3, and C are corporations, A and B are individuals, shareholders are not treated as one person under section 355(d)(7), stock has been owned for more than five years and section 355(d)(6) and paragraph (e)(4) of this section do not apply, no election under section 338 (if available) is made, and all transactions described are respected under general tax principles, including the step transaction doctrine. No inference should be drawn from any example as to whether any requirements of section 355 other than those of section 355(d), as specified, are satisfied.
(2) Fiveyear period. For purposes of this section, the term five year period means the fiveyear period (determined after applying section 355(d)(6) and paragraph (e)(4) of this section) ending on the date of the distribution, but in no event beginning earlier than October 10, 1990.
(3) Distributing securities. For purposes of determining if stock of any controlled corporation received in the distribution is disqualified stock described in section 355(d)(3)(B)(ii)(II) (relating to a distribution of controlled corporation stock on any securities in the distributing corporation acquired by purchase during the fiveyear period), references in this section to stock of a corporation that is or becomes a distributing corporation includes securities of the corporation. Similarly, a reference to stock in paragraph (c)(4) of this section (relating to a plan or arrangement) includes securities. (4) Marketable securities. Unless otherwise stated, any reference in this section to marketable stock includes marketable securities. (b) General rules and purposes of section 355(d)(1) Disqualified distributions in general. In the case of a disqualified distribution, any stock or securities in the controlled corporation shall not be treated as qualified property for purposes of section 355(c)(2) or 361(c)(2). In general, a disqualified distribution is any distribution to which section 355 (or so much of section 356 as relates thereto) applies if, immediately after the distribution
(i) Any person holds disqualified stock in the distributing corporation that constitutes a 50 percent or greater interest in such corporation; or
(ii) Any person holds disqualified stock in the controlled corporation (or, if stock of more than one controlled corporation is distributed, in any controlled corporation) that constitutes a 50 percent or greater interest in such corporation.
(2) Disqualified stock(i) In general. Disqualified stock is (A) Any stock in the distributing corporation acquired by purchase during the fiveyear period; and
(B) Any stock in any controlled corporation
(1) Acquired by purchase during the fiveyear period; or [[Page 79724]]
(2) Received in the distribution to the extent attributable to distributions on any stock in the distributing corporation acquired by purchase during the fiveyear period.
(ii) Purchase. For the definition of a purchase for purposes of section 355(d) and this section, see section 355(d)(5) and paragraph (d) of this section.
(iii) Exceptions(A) Purchase eliminated. Stock (or an interest in another entity) that is acquired by purchase (including stock (or another interest) that is treated as acquired by purchase under paragraph (e)(2), (3), or (4) of this section) ceases to be acquired by that purchase if (and when) the basis resulting from the purchase is eliminated. For purposes of this paragraph (b)(2)(iii), basis resulting from the purchase is basis in the stock (or in an interest in another entity) that is directly purchased during the fiveyear period or that is treated as acquired by purchase during such period under paragraph (e)(2), (3), or (4) of this section.
(B) Deemed purchase eliminated. Stock (or an interest in another entity) that is deemed purchased under section 355(d)(8) or paragraph (e)(1) of this section shall cease to be treated as purchased if (and when) the basis resulting from the purchase that effects the deemed purchase is eliminated.
(C) Elimination of basis(1) General rule. Basis in the stock of a corporation (or in an interest in another entity) is eliminated if (and when) it would no longer be taken into account by any person in determining gain or loss on a sale or exchange of any stock of such corporation (or an interest in the other entity). Basis is not eliminated, however, if it is allocated between stock of two corporations under Sec. 1.3582(a).
(2) Special rule for transferred and exchanged basis property. Basis of stock (or an interest in another entity) resulting from a purchase (the first purchase) is eliminated if (and when) such stock (or other interest) is subsequently transferred to another person in an exchange or other transfer to which paragraph (e)(2) or (3) of this section applies (the second purchase). The elimination of basis in stock (or in another interest) resulting from the first purchase, however, does not eliminate the basis resulting from the second purchase in the stock (or other interest) that is treated as acquired by purchase by the acquirer in a transaction to which paragraph (e)(2) of this section applies or by the person making the exchange in a transaction to which paragraph (e)(3) of this section applies. (3) Special rule for Splitoffs and Splitups. Under section 355(d)(3)(B)(ii) and paragraph (b)(2)(i)(B)(2) of this section, disqualified stock includes controlled corporation stock received in exchange for distributing corporation stock acquired by purchase. Solely for purposes of determining whether controlled corporation stock received in a distribution in exchange for distributing corporation stock is disqualified stock described in that section and paragraph immediately after the distribution, paragraph (b)(2)(iii)(C)(2) of this section does not apply to the exchange to eliminate basis resulting from a purchase of that distributing corporation stock (notwithstanding that paragraph (e)(3) of this section applies to the exchange). (D) Special rule if basis allocated between two corporations. If the shareholder of a distributing corporation, pursuant to Sec. 1.358 2, allocates basis resulting from a purchase between the stock of two or more corporations then, following such allocation, the determination of whether such basis has been eliminated shall be made separately with respect to the stock of each such corporation.
(3) Certain distributions not disqualified distributions because purposes of section 355(d) not violated(i) In general.
Notwithstanding the provisions of section 355(d)(2) and this paragraph (b), a distribution is not a disqualified distribution if the distribution does not violate the purposes of section 355(d) as provided in this paragraph (b)(3). A distribution does not violate the purposes of section 355(d) if the effect of the distribution is neither
(A) To increase ownership (combined direct and indirect) in the distributing corporation or any controlled corporation by a disqualified person; nor
(B) To provide a disqualified person with a purchased basis in the stock of any controlled corporation.
(ii) Disqualified person. A disqualified person is any person (taking into account section 355(d)(7) and paragraph (c)(4) of this section) that, immediately after a distribution, holds (directly or indirectly under section 355(d)(8) and paragraph (e)(1) of this section) disqualified stock in the distributing corporation or controlled corporation that
(A) The person
(1) Acquired by purchase under section 355(d)(5) or (8) and paragraphs (d) and (e) of this section during the fiveyear period, or (2) Received in the distribution to the extent attributable to distributions on any stock in the distributing corporation acquired by purchase under section 355(d)(5) or (8) and paragraphs (d) and (e) of this section by that person during the fiveyear period; and (B) Constitutes a 50 percent or greater interest in such corporation (under section 355(d)(4) and paragraph (c) of this section).
(iii) Purchased basis. In general, a purchased basis is basis in controlled corporation stock that is disqualified stock. However, basis in controlled corporation stock that is disqualified stock will not be treated as purchased basis if the controlled corporation stock and any distributing corporation stock with respect to which the controlled corporation stock is distributed are treated as acquired by purchase solely under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. The prior sentence will not apply, however, if the distributing corporation stock is treated as acquired by purchase under the attribution rules as a result of the acquisition of an interest in a partnership (the purchased partnership), and following the distribution, the controlled corporation stock is directly held by the purchased partnership (or a chain of partnerships that includes the purchased partnership).
(iv) Increase in interest because of payment of cash in lieu of fractional shares. Any increase in direct or indirect ownership in the distributing corporation or any controlled corporation by a disqualified person because of a payment of cash in lieu of issuing fractional shares will be disregarded for purposes of paragraph (b)(3)(i)(A) of this section if the payment of the cash is solely to avoid the expense and inconvenience of issuing fractional share interests, and does not represent separately bargained for consideration.
(v) Other exceptions. The Commissioner may provide by guidance published in the Internal Revenue Bulletin that other distributions are not disqualified distributions because they do not violate the purposes of section 355(d).
(vi) Examples. The following examples illustrate this paragraph (b)(3):

Example 1. Stock distributed in spinoff; no purchased basis. D owns all of the stock of D1, and D1 owns all the stock of C. A purchases 60 percent of the D stock for cash. Within five years of A's purchase, D1 distributes the C stock to D. A is treated as having purchased 60 percent of the stock of both D1 and C on the date A purchases 60 percent of the D stock under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. The C stock received by D is attributable to a distribution on purchased D1 stock under section 355(d)(3)(B)(ii). Accordingly, the D1 and C stock each is
[[Page 79725]]
disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section, and A is a disqualified person under paragraph (b)(3)(ii) of this section. However, the purposes of section 355(d) under paragraph (b)(3)(i) of this section are not violated. A did not increase direct or indirect ownership in D1 or C. In addition, D's basis in the C stock is not a purchased basis under paragraph (b)(3)(iii) of this section because both the D1 and the C stock are treated as acquired by purchase solely under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. Accordingly, D1's distribution of the C stock to D is not a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 2. Stock distributed in spinoff; purchased basis. The facts are the same as Example 1, except that D immediately further distributes the C stock to its shareholders (including A) pro rata. The D and C stock each is disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section, and A is a disqualified person under paragraph (b)(3)(ii) of this section. The purposes of section 355(d) under paragraph (b)(3)(i) of this section are violated. A did not increase direct or indirect ownership in D or C. However, A's basis in the C stock is a purchased basis under paragraph
(b)(3)(iii) of this section because the D stock is not treated as acquired by purchase solely under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. Accordingly, the further distribution is a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 3. Stock distributed in splitoff with ownership increase; purchased basis. The facts are the same as Example 1, except that D immediately further distributes the C stock to A in exchange for A's purchased stock in D. The C stock received by A is attributable to a distribution on purchased D stock under section 355(d)(3)(B)(ii), and A's basis in the C stock is determined by reference to the adjusted basis of A's purchased D stock under paragraph (e)(3) of this section. (Under paragraph (b)(2)(iii)(B)(3) of this section, the basis resulting from A's purchase of D stock is not eliminated solely for purposes of determining if the C stock acquired by A is disqualified stock immediately after the
distribution, notwithstanding that paragraph (e)(3) of this section applies to the exchange.) Accordingly, the D stock and the C stock each is disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section, and A is a disqualified person under paragraph (b)(3)(ii) of this section. The purposes of section 355(d) under paragraph (b)(3)(i) of this section are violated because A increased its ownership in C from a 60 percent indirect interest to a 100 percent direct interest, and because A's basis in the C stock is a purchased basis under paragraph (b)(3)(iii) of this section. Accordingly, the further distribution is a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 4. Stock distributed in spinoff; purchased basis. D1 owns all the stock of C. D purchases all of the stock of D1 for cash. Within five years of D's purchase of D1, P acquires all of the stock of D1 from D in a section 368(a)(1)(B) reorganization that is not a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(E), and D1 distributes all of its C stock to P. P is treated as having acquired the D1 stock by purchase on the date D acquired it under the transferred basis rule of section 355(d)(5)(C) and paragraph (e)(2) of this section. P is treated as having purchased all of the C stock on the date D purchased the D1 stock under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section, and the C stock received by P is
attributable to a distribution on purchased D1 stock under section 355(d)(3)(B)(ii). Accordingly, the D1 and C stock each is
disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section, and P is a disqualified person under paragraph (b)(3)(ii) of this section. The purposes of section 355(d) under paragraph (b)(3)(i) of this section are violated. P did not increase direct or indirect ownership in D1 or C. However, P's basis in the C stock is a purchased basis under paragraph (b)(3)(iii) of this section because the D1 stock is not treated as acquired by purchase solely under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. Accordingly, D1's distribution of the C stock to P is a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 5. Stock distributed in splitoff with ownership increase; no purchased basis. P owns 50 percent of the stock of D, the remaining D stock is owned by unrelated persons, D owns all the stock of C, and A purchases all of the P stock from the P
shareholders. Within five years of A's purchase, D distributes all of the C stock to P in exchange for P's D stock. A is treated as having purchased 50 percent of the stock of both D and C on the date A purchases the P stock under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. The C stock received by P is attributable to a distribution on purchased D stock under section 355(d)(3)(B)(ii). Accordingly, the D stock and the C stock each is disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section, and A is a disqualified person under paragraph (b)(3)(ii) of this section. The purposes of section 355(d) under paragraph (b)(3)(i) of this section are violated because, even though P's basis in the C stock is not a purchased basis under paragraph (b)(3)(iii) of this section, A increased its direct or indirect ownership in C from a 50 percent indirect interest to a 100 percent indirect interest. Accordingly, D's distribution of the C stock to P is a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 6. Stock distributed in splitoff with no ownership increase; no purchased basis. A purchases all of the stock of T. T later merges into D in a section 368(a)(1)(A) reorganization and A exchanges its purchased T stock for 60 percent of the stock of D. D owns all of the stock of D1 and D2, D1 and D2 each owns 50 percent of the stock of D3, and D3 owns all of the stock of C. Within five years of A's purchase of the T stock, D3 distributes the C stock to D1 in exchange for all of D1's D3 stock. A is treated as having acquired 60 percent of the D stock by purchase on the date A purchases the T stock under paragraph (e)(3) of this section. A is treated as having purchased 60 percent of the stock of D1, D2, D3, and C on the date A purchases the T stock under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. The C stock received by D1 is attributable to a distribution on purchased D3 stock under section 355(d)(3)(B)(ii). Accordingly, the D3 stock and the C stock each is disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section, and A is a disqualified person under paragraph (b)(3)(ii) of this section. However, the purposes of section 355(d) under paragraph (b)(3)(i) of this section are not violated. A did not increase direct or indirect ownership in D3 or C, and D1's basis in the C stock is not a purchased basis under paragraph (b)(3)(iii) of this section because the D3 stock is treated as acquired by purchase solely under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. Accordingly, D3's distribution of the C stock to D1 is not a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 7. Purchased basis eliminated by liquidation; stock distributed in spinoff. P owns 30 percent of the stock of D, D owns all of the stock of D1, and D1 owns all of the stock of C. P purchases the remaining 70 percent of the D stock for cash. Within five years of P's purchase, P liquidates D in a transaction qualifying under sections 332 and 337(a), and D1 then distributes the stock of C to P. Prior to the liquidation, P is treated as having purchased 70 percent of the stock of D1 and C on the date P purchases the D stock under the attribution rules of section 355(d)(8)(B) and paragraph (e)(1) of this section. After the liquidation, however, under paragraph (b)(2)(iii) of this section, P is not treated as having acquired by purchase the D1 or the C stock under section 355(d)(8)(B) and paragraph (e)(1) of this section because P's basis in the D stock is eliminated in the liquidation of D. Under section 334(b)(1), P's basis in the D1 stock is determined by reference to D's basis in the D1 stock and not by reference to P's basis in D. Paragraph (d)(2)(i)(B) of this section does not treat the D1 stock as newly purchased in P's hands because no gain or loss was recognized by D in the liquidation. Accordingly, neither the D1 stock nor the C stock is disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section in P's hands, and the distribution is not a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 8. Purchased basis eliminated by upstream merger; stock distributed in spinoff. D owns all of the stock of D1, and D1 owns all of the stock of C. P purchases 60 percent of the D stock for cash. Within five years of P's purchase, D merges into P in a section 368(a)(1)(A) reorganization, with the D shareholders other than P receiving solely P stock in exchange for their D stock, and D1 then distributes the stock of C to P. Prior to the merger, P is treated as having purchased 60 percent of the stock of D1 and C on the date P purchases the D stock under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. After the [[Page 79726]]
merger, however, under paragraph (b)(2)(iii) of this section, P is not treated as having acquired by purchase the D1 or the C stock under section 355(d)(8)(B) and paragraph (e)(1) of this section because P's basis in the D stock is eliminated in the merger. Under section 362(b), P's basis in the D1 stock is determined by reference to D's basis in the D1 stock and not by reference to P's basis in D. Paragraph (d)(2)(i)(B) of this section does not treat the D1 stock as newly purchased in P's hands because no gain or loss was recognized by D in the merger. Accordingly, neither the D1 stock nor the C stock is disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section in P's hands, and the distribution is not a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section.

Example 9. Purchased basis eliminated by distribution; stock distributed in spinoff. A purchases all the stock of C for cash on Date 1. D acquires all of the stock of C from A in a section 368(a)(1)(B) reorganization that is not a reorganization under section 368(a)(1)(A) by reason of section 368(A)(1)(E). A receives ten percent of the D stock in the transaction. The remaining D stock is owned by B. Within five years of A's purchase of the C stock, D distributes all the stock of C pro rata to A and B. Under the transferred basis rule of paragraph (e)(2) of this section, D is treated as having purchased all of the C stock on the date A acquired it. Under the exchanged basis rule of paragraph (e)(3) of this section, A is treated as having purchased its D stock on Date 1 and A is treated as having purchased ten percent of the C stock on Date 1 under the attribution rules of section 355(d)(8) and paragraph (e)(3) of this section. Moreover, under paragraph (b)(2)(iii)(C) of this section, A's basis in the C stock resulting from A's Date 1 purchase of C stock is eliminated. After the distribution, A's and B's bases in their C stock are determined by reference to the bases of their D stock under Sec. 1.3582(a)(2) (and not by reference to D's basis in the C stock). D's basis in the stock of C resulting from its deemed purchase of that stock under paragraph (e)(2) of this section is eliminated by the distribution of the C stock because it would no longer be taken into account by any person in determining gain or loss on the sale of C stock. Therefore, the C stock distributed to A and B is not disqualified stock as a result of D's purchase of C. However, A's basis in its D stock resulting from its deemed purchase of that stock under paragraph (e)(3) of this section is not eliminated. Therefore, A's ten percent interest in the stock of D is disqualified stock. Furthermore, A's ten percent interest in the stock of C is disqualified stock because the distribution of the C stock is attributable to A's D stock that was acquired by purchase. However, there has not been a disqualified distribution because no person, immediately after the distribution, holds disqualified stock in either D or C that constitutes a 50 percent or greater interest in such corporation.

Example 10. Allocation of purchased basis analyzed separately. (i) P owns all the stock of D. D purchases all the stock of D1 for cash on Date 1. D1 owns all the stock of C (which owns all the stock of C1) and S. Within five years of Date 1, D1 distributes all the stock of C to D. The D1 and C stock each is disqualified stock under section 355(d)(3) and paragraph (b)(2) of this section, and D is a disqualified person under paragraph (b)(3)(ii) of this section. The purposes of section 355(d) under paragraph (b)(3)(i) of this section are violated. D did not increase direct or indirect ownership in D1 or C. However, D's basis in the C stock is a purchased basis under paragraph (b)(3)(iii) of this section because the D1 stock is not treated as acquired by purchase solely under the attribution rules of section 355(d)(8) and paragraph (e)(1) of this section. Accordingly, the distribution is a disqualified distribution under section 355(d) and paragraph (b)(1) of this section. D's basis in the D1 stock is allocated pursuant to Sec. 1.3582 between the D1 stock and the C stock. Therefore, under paragraph (e)(4) of this section, the C stock is deemed to be acquired by purchase on Date 1, the date D purchased all the stock of D1. If thereafter, and within five years of Date 1, C were to distribute all the stock of C1 to D, that distribution would also be a disqualified distribution because of D's deemed purchase of the stock of C.
(ii) Following the distribution of the stock of C by D1, and within five years of Date 1, D distributes all the stock of D1 to P. Under paragraph (b)(2)(iii)(D) of this section, the determination of whether D's basis in D1 has been eliminated shall be made without regard to D's allocated basis in C. After the distribution, P's basis in the D1 stock is determined by reference to its basis in its D stock under Sec. 1.3582(a)(2) (and not by reference to D's basis in the D1 stock). D's basis in the D1 stock resulting from the purchase of that stock is eliminated by the distribution of the D1 stock because it would no longer be taken into account by any person in determining gain or loss on the sale of D1 stock. Therefore, the D1 stock distributed to P is not disqualified stock as a result of D's purchase of D1. Moreover, a subsequent distribution of the S stock by D1 to P would not be a disqualified distribution because both the D1 and S stock would cease to be treated as purchased when D's basis in D1 has been eliminated.
(4) Antiavoidance rule(i) In general. Notwithstanding any provision of section 355(d) or this section, the Commissioner may treat any distribution as a disqualified distribution under section 355(d)(2) and paragraph (b)(1) of this section if the distribution or another transaction or transactions are engaged in or structured with a principal purpose to avoid the purposes of section 355(d) or this section with respect to the distribution. Without limiting the preceding sentence, the Commissioner may determine that the existence of a related person, intermediary, passthrough entity, or similar person (an intermediary) should be disregarded, in whole or in part, if the intermediary is formed or availed of with a principal purpose to avoid the purposes of section 355(d) or this section.
(ii) Example. The following example illustrates this paragraph (b)(4):

Example. Postdistribution redemption. B wholly owns D, which wholly owns C. With a principal purpose to avoid the purposes of section 355(d), A, B, D, and C engage in the following transactions. A purchases 45 of 100 shares of the only class of D stock. Within five years after A's purchase, D distributes all of its 100 shares in C to A and B pro rata. D then redeems 20 shares of B's D stock, and C redeems 20 shares of B's C stock. After the redemption, A owns 45 shares and B owns 35 shares in each of D and C. Under paragraph (b)(4)(i) of this section, the Commissioner may treat A as owning disqualified stock in D and C that constitutes a 50 percent or greater interest in D and C immediately after the distribution. Under that treatment, the distribution is a disqualified
distribution under section 355(d)(2) and paragraph (b)(1) of this section.
(c) Whether a person holds a 50 percent or greater interest(1) In general. Under section 355(d)(4), 50 percent or greater interest means stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock.
(2) Valuation. For purposes of section 355(d)(4) and this section, all shares of stock within a single class are considered to have the same value. But see paragraph (c)(3)(vii)(A) of this section (determination of whether it is reasonably certain that an option will be exercised).
(3) Effect of options, warrants, convertible obligations, and other similar interests(i) Application. This paragraph (c)(3) provides rules to determine when an option is treated as exercised for purposes of section 355(d) (other than section 355(d)(6)). Except as provided in this paragraph (c)(3), an option is not treated as exercised for purposes of section 355(d). This paragraph (c)(3) does not affect the determination of whether an instrument is an option or stock under general principles of tax law (such as substance over form). (ii) General rule. In determining whether a person has acquired by purchase a 50 percent or greater interest under section 355(d)(4), an option to acquire stock (as described in paragraphs (c)(3)(v) and (vi) of this section) that has not been exercised when a distribution occurs is treated as exercised on the date it was issued or most recently transferred if
(A) Its exercise (whether by itself or in conjunction with the deemed exercise of one or more other options) would cause a person to become a disqualified person; and
[[Page 79727]]
(B) Immediately after the distribution, it is reasonably certain (as described in paragraph (c)(3)(vii) of this section) that the option will be exercised.
(iii) Options deemed newly issued and substituted options(A) Exchange, adjustment, or alteration of existing option. For purposes of this paragraph (c)(3), each of the following is treated as a new issuance or transfer of an existing option only if it materially increases the likelihood that an option will be exercised
(1) An exchange of an option for another option or options; (2) An adjustment to the terms of an option (including an adjustment pursuant to the terms of the option);
(3) An adjustment to the terms of the underlying stock (including an adjustment pursuant to the terms of the stock);
(4) A change to the capital structure of the issuing corporation; and
(5) An alteration to the fair market value of issuing corporation stock through an asset transfer (other than regular, ordinary dividends) or through any other means.
(B) Certain compensatory options. An option described in paragraph (c)(3)(vi)(B)(2) of this section is treated as issued on the date it becomes transferable.
(C) Substituted options. If an option (existing option) is exchanged for another option or options (substituted option or options) and paragraph (c)(3)(iii)(A) of this section does not apply to treat such exchange as a new issuance or transfer of the existing option, the substituted option or options will be treated as issued or most recently transferred on the date that the existing option was issued or most recently transferred.
(iv) Effect of treating an option as exercised(A) In general. For purposes of section 355(d), an option that is treated as exercised under this paragraph (c)(3) is treated as exercised both for purposes of determining the percentage of the voting power of stock owned by the holder and for purposes of determining the percentage of the value of stock owned by the holder.
(B) Stock purchase agreement or similar arrangement. If a stock purchase agreement or similar arrangement is deemed exercised, the purchaser is treated as having purchased the stock under the terms of the agreement or arrangement as though all covenants had been satisfied and all contingencies met. The agreement or arrangement is deemed to have been exercised as of the date it is entered into or most recently assigned.
(v) Instruments treated as options. For purposes of this paragraph (c)(3), except to the extent provided in paragraph (c)(3)(vi) of this section, the following are treated as options: A call option, warrant, convertible obligation, the conversion feature of convertible stock, put option, redemption agreement (including a right to cause the redemption of stock), notional principal contract (as defined in Sec. 1.4463(c)) that provides for the payment of amounts in stock, stock purchase agreement or similar arrangement, or any other instrument that provides for the right to purchase, issue, redeem, or transfer stock (including an option on an option).
(vi) Instruments generally not treated as options. For purposes of this paragraph (c)(3), the following are not treated as options, unless issued, transferred, or listed with a principal purpose to avoid the application of section 355(d) or this section:
(A) Escrow, pledge, or other security agreements. An option that is part of a security arrangement in a typical lending transaction (including a purchase money loan), if the arrangement is subject to customary commercial conditions. For this purpose, a security arrangement includes, for example, an agreement for holding stock in escrow or under a pledge or other security agreement, or an option to acquire stock contingent upon a default under a loan.
(B) Compensatory options(1) General rule. An option to acquire stock in a corporation with customary terms and conditions, provided to an employee, director, or independent contractor in connection with the performance of services for the corporation or a person related to it under section 355(d)(7)(A) (and that is not excessive by reference to the services performed) and that
(i) Is nontransferable within the meaning of Sec. 1.833(d); and (ii) Does not have a readily ascertainable fair market value as defined in Sec. 1.837(b).
(2) Exception. Paragraph (c)(3)(vi)(B)(1) of this section ceases to apply to an option that becomes transferable.
(C) Certain stock conversion features. The conversion feature of convertible stock, provided that
(1) The stock is not convertible for at least five years after issuance or transfer; and
(2) The terms of the conversion feature do not require the tender of any consideration other than the stock being converted.
(D) Options exercisable only upon death, disability, mental incompetency, or separation from service. Any option entered into between stockholders of a corporation (or a stockholder and the corporation) with respect to the stock of either stockholder that is exercisable only upon the death, disability, mental incompetency of the stockholder, or, in the case of stock acquired in connection with the performance of services for the corporation or a person related to it under section 355(d)(7)(A) (and that is not excessive by reference to the services performed), the stockholder's separation from service. (E) Rights of first refusal. A bona fide right of first refusal regarding the corporation's stock with customary terms, entered into between stockholders of a corporation (or between the corporation and a stockholder).
(F) Other enumerated instruments. Any other instruments specified in regulations, a revenue ruling, or a revenue procedure. See Sec. 601.601(d)(2) of this chapter.
(vii) Reasonably certain that the option will be exerci

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