Many years ago the IRS ruled in Rev. Rul. 55-355 that a shareholder has to assign tax basis to the shares received in a reorganization by using the average tax basis of the shares given up. Subsequently, the courts and the IRS have gradually given taxpayers more leeway to allocate the basis of shares given up to specific shares received. For example, the courts have given taxpayers the ability to specifically identify the old shares’ tax basis to the new shares’ tax basis; see Bloch, 148 F2 452 (9th Cir. 1945), and Leonard Osrow, 49 TC 333 (1968), while the IRS issued technical advice (TAM 7946005) that allows taxpayers to trace the basis from the old shares to the new shares. One treatise (Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, Seventh Ed., Warren, Gorham & Lamont, para. 12.44[3][c]) viewed the old ruling as merely a matter of administrative convenience.

Final Regs.

In 2004, the IRS issued proposed regulations permitting taxpayers to specifically identify the tax basis of  shares received in a reorganization when certain criteria are met. The proposed regulations recently became final. Regs. Sec. 1.358-2 applies to exchanges and distributions of stock and securities occurring after Jan. 22, 2006. Despite this effective date, the fact that Treasury issued the proposed regulations in 2004 suggests that it would accept this new approach for transactions that were in accordance with the final regulations before the effective date.

A specific allocation method for determining the tax basis of shares received in a reorganization may be quite useful when calculating the tax consequences of a future disposition. For example, a taxpayer planning to contribute shares to a qualifying charity would prefer to select the shares with the lowest tax basis because he or she will not pay tax on the appreciation. Or a taxpayer who contemplates giving shares as gifts to family members would prefer to select the shares with the highest tax basis because the donee must use the donor’s tax basis for the donated property if it is sold or ex-changed at a gain.

Taxpayers who would like to sell shares after a reorganization may prefer to select which blocks to retain and which blocks to sell. Being able to allocate the historic basis among the blocks received gives more control to taxpayers who prefer to make specific identifications.

The proposed regulations outlined the limits and included seven helpful examples. Based on comment letters, Treasury added seven more examples to give additional guidance.

One change in the final regulations allows basis allocations to follow the terms of an exchange when the terms specify which shares are being ex-changed for particular new shares. However, there is a qualification: the transaction’s terms must be economically reasonable. This approach is illustrated in Regs. Sec. 1.358-2(c), Example (5) and Example (6), when the terms are respected when making the basis allocations.

The preamble to the final regulations explains a potential trap for the unwary and requests comments about further regulatory amendments. The trap relates to an exchange of common and preferred stock in one corporation for stock in another corporation plus cash. The terms of the exchange spell out that the preferred stock is being exchanged solely for cash, but in this instance (as opposed to the facts in Regs. Sec. 1.358-2(c), Example (4)), the cash portion of the transaction produces a loss. Because the new regulations respect the terms of the ex-change, the loss cannot be recognized. This treatment is consistent with Rev. Rul. 74-515, but leaves open the question of how the unrecognized loss will affect the tax basis.

Regs. Sec. 1.358-2(c) adds examples to explain the allocation of basis in boot transactions (Example (5)), as well as examples that explain how taxpayers will be treated when no shares are held or only part of the shares held are surrendered in the transaction (Example (10) and Example (11)).

Example (13) provides further guidance on Sec. 355 transactions in which some shares are surrendered. It most vividly illustrates the flexibility of the taxpayer designation rule.

Example (13): Taxpayer, T, owns 40 shares of Corporation X. One block of 20 shares costs $2 a share, and the other block of 20 shares costs $4 a share. X owns 40 shares (100%) of Corporation Y stock. Each X share is worth $80 and each Y share is worth $40. T receives 20 Y shares in exchange for 20 X shares, and continues to hold the remaining 20 X shares. T can designate the Y stock basis to be either $2 a share or $4 a share.

Perhaps the most helpful addition to the final regulation is new Example (14), which illustrates the concept of the “split basis” share.

Example (14): Taxpayer, T, owns 40 Corporation X shares bought in four separate blocks of 10 shares each. These are exchanged for 30 shares of Corporation Y. Twenty-eight shares are issued with basis allocated from the original four blocks. The remaining two shares have split tax basis from the four original blocks. The result is illustrated in the exhibit.

Finally, it is essential for taxpayers to make proper designations. The final regulations are unchanged from the proposed regulations as to when designations must be made. However, neither the proposed nor the final regulations include specific guidance about the form and content of the designation. Needless to say, the taxpayer’s permanent records must reflect designations. However, who should receive information about a designation, and how a designation should be communicated, are not explained. Generally, a designation would be directed to a transferee (donee or charity) or to a stockbroker (for a sale transaction).

From Diane Clifton, CPA, Bethesda, MD