Final basis regs. provide deferral opportunities in tax-free exchanges.

• Author: Gruidl, Nick

Final regulations addressing basis and boot in reorganizations provide interesting and unexpected results. Secs. 358 and 356 address allocation of basis to property received in a reorganization and gain recognition on receipt of boot, respectively.

Proposed regulations (REG-116564-03, 5/3/04) provided a tracing method for allocating basis under Sec. 358 in Sec. 368 reorganizations and Sec. 355 distributions. Under this method, each share of stock received is traced to the share surrendered for Sec. 368 reorganizations; each share received in a Sec. 355 distribution is allocated basis from a share of stock of the distributing corporation.

The preamble to the final regulations explains that the IRS and Treasury adopted the tracing method because they felt the averaging of bases of stock that may have been purchased at different times and different prices was not justified under the substituted-basis rule of See. 358; see TD 9244 (1/23/06). They were also concerned that averaging would not allow taxpayers to properly arrange their affairs and might create opportunities for tax avoidance.

Final Regs.

The final regulations retain the tracing method and provide that if the parties to a reorganization specify in the terms which particular share or class of stock is being exchanged for another particular share or class, and the allocation is economically reasonable, the terms of the agreement control.

For example, if common stock is exchanged for common and preferred stock of another corporation or stock and boot, the terms of the agreement could specify which blocks (shares acquired at different dates or prices) were exchanged for common stock and which shares were exchanged for preferred stock or boot; see Regs. Sec. 1.358-2(a)(2)(ii). If economically reasonable, the terms would control. If the terms are not specified, a pro-rata portion of shares of each class is received in exchange for each share of stock surrendered, in accordance with the fair market value (FMV) of the stock surrendered.

Allocating boot: The regulations also provide rules for allocating boot received when determining gain recognition. As with qualifying consideration, boot may be allocated consistent with the rules above--i.e., if the terms specify the allocation of boot received in the exchange and the allocation is economically reasonable, it will be respected; see Regs. Sec. 1.356-1(b). If the terms do not specify, a pro-rata portion of boot is treated as received in...