Td 9097

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 148.—Arbitrage
26 CFR 1.148–5: Yield and valuation of investments.

T.D. 9097
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1
Arbitrage Restrictions Applicable
to Tax-Exempt Bonds Issued by
State and Local Governments
AGENCY: Internal
(IRS), Treasury.

Revenue

Service

418 [64 FR 46876]) (the proposed regulations). The proposed regulations modify §1.148–5(e)(2) to provide a safe harbor for determining whether brokers' commissions and similar fees incurred in connection with the acquisition of guaranteed
investment contracts or investments purchased for a yield restricted defeasance escrow are treated as qualified administrative costs. Comments on the proposed regulations were received and a hearing was
held on December 14, 1999. After consideration of all the comments, the proposed
regulations are adopted as revised by this
Treasury decision. The revisions are discussed below.
Explanation of Provisions

ACTION: Final regulations.
I. Existing Regulations
SUMMARY: This document contains
final regulations on the arbitrage restrictions applicable to tax-exempt bonds
issued by state and local governments.
The regulations affect issuers of tax-exempt bonds and provide a safe harbor for
qualified administrative costs for broker's
commissions and similar fees incurred in
connection with the acquisition of guaranteed investment contracts or investments
purchased for a yield restricted defeasance
escrow.
DATES: Effective Date: These regulations
are effective February 9, 2004.
Applicability Date: For dates of applicability, see §1.148–11(i) of these regulations.
FOR
FURTHER
INFORMATION
CONTACT: Rose M. Weber, (202)
622–3980 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document amends 26 CFR part
1 under section 148 of the Internal Revenue Code by providing rules for determining when certain brokers' commissions
or similar fees are qualified administrative
costs (the final regulations). On August
27, 1999, the IRS published in the Federal Register a notice of proposed rulemaking (REG–105565–99, 1999–2 C.B.

2003-52 I.R.B.

A. Investment yield and administrative
costs
Section 148 limits the yield on investments purchased with proceeds of
tax-exempt bonds. In general, under
§1.148–5(b)(1) of the existing regulations,
the yield on an investment is computed
by comparing receipts from the investment to payments for the investment.
Section 1.148–5(e)(1) provides that the
yield on an investment generally is not
adjusted to take into account any costs
or expenses paid, directly or indirectly,
to purchase, carry, sell, or retire the investment (administrative costs). However,
§1.148–5(e)(2)(i) provides that the yield
on nonpurpose investments (as defined
in §1.148–1(b)) is adjusted to take into
account qualified administrative costs.
Qualified administrative costs are reasonable, direct administrative costs, other than
carrying costs, such as separately stated
brokerage or selling commissions, but not
legal and accounting fees, recordkeeping,
custody, and similar costs. In general,
under §1.148–5(e)(2)(i), administrative
costs are not reasonable unless they are
comparable to administrative costs that
would be charged for the same investment
or a reasonably comparable investment if
acquired with a source of funds other than
gross proceeds of tax-exempt bonds (the
comparability standard).

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B. Special rule for guaranteed investment
contracts
Section 1.148–5(e)(2)(iii) of the existing regulations provides that, for a guaranteed investment contract, a broker's commission or similar fee paid on behalf of
either an issuer or the guaranteed investment contract provider generally is a qualified administrative cost to the extent that
the present value of the commission, as of
the date the contract is allocated to the issue, does not exceed the lesser of (x) a
reasonable amount within the meaning of
§1.148–5(e)(2)(i) or (y) the present value
of annual payments equal to .05 percent
of the weighted average amount reasonably expected to be invested each year of
the term of the contract. Present value is
computed using the taxable discount rate
used by the parties to compute the commission, or if not readily ascertainable, the
yield to the issuer on the investment contract or other reasonable taxable discount
rate.
C. Special rule for yield restricted
defeasance escrows
Section 1.148–5(e)(2)(iv) of the existing regulations provides that, for investments purchased for a yield restricted
defeasance escrow, a fee paid to a bidding agent is a qualified administrative
cost only if the fee is comparable to a fee
that would be charged for a reasonably
comparable investment if acquired with a
source of funds other than gross proceeds
of tax-exempt bonds, and it is reasonable.
The fee is deemed to meet both the comparability and reasonableness requirements
if it does not exceed the lesser of $10,000
or .1 percent of the initial principal amount
of investments deposited in the yield restricted defeasance escrow.
II. Proposed Regulations
The proposed regulations were issued
in response to comments stating that
issuers were having difficulty applying
§1.148–5(e)(2)(iii) and (iv), primarily
because of uncertainty about whether a
particular broker's commission or similar
fee is reasonable. The proposed regulations delete the existing provisions of

December 29, 2003

§1.148–5(e)(2)(iii) and (iv) and create a
single rule for qualified administrative
costs that treats a broker's commission or
similar fee incurred in connection with
a guaranteed investment contract or investments purchased for a yield restricted
defeasance escrow as a qualified administrative cost if the fee is reasonable within
the meaning of §1.148–5(e)(2)(i) of the
existing regulations.
The proposed regulations also set forth
a safe harbor, which treats a broker's
commission or similar fee incurred in
connection with the acquisition of a guaranteed investment contract or investments
purchased for a yield restricted defeasance
escrow as reasonable within the meaning
of §1.148–5(e)(2)(i) if two requirements
are met. Under the first requirement for
the safe harbor, the amount of the broker's
commission or similar fee treated by the
issuer as a qualified administrative cost
cannot exceed the lesser of $25,000 or
0.2 percent of the computational base
(the per-investment safe harbor). For
guaranteed investment contracts, the computational base is the aggregate amount
reasonably expected as of the issue date to
be deposited over the term of the contract.
For example, for a guaranteed investment
contract used to earn a return on what otherwise would be idle cash balances from
maturing investments in a yield restricted
defeasance escrow, the aggregate amount
reasonably expected to be deposited includes all periodic deposits reasonably
expected to be made pursuant to the terms
of the contract. For investments, other
than guaranteed investment contracts,
deposited in a yield restricted defeasance
escrow, the computational base is the initial amount invested in those investments.
Under the second requirement for the safe
harbor, for any issue of bonds, the issuer
cannot treat as qualified administrative
costs more than $75,000 in brokers' commissions or similar fees with respect to
all guaranteed investment contracts and
investments for yield restricted defeasance
escrows purchased with gross proceeds of
the issue (the per-issue safe harbor).

December 29, 2003

III. Final Regulations
A. Safe harbor approach
Some commentators suggested that the
existing regulations, coupled with competitive market forces, work well to produce
reasonable brokers' fees. Commentators
also suggested that the proposed regulations will eliminate much of the incentive
for the independent bidding agent to actively participate in the market, with the result that, in many cases, tax-exempt bond
proceeds will be placed in lower-yielding
and often riskier investments. These commentators recommended against adopting
the safe harbor in the proposed regulations.
Other commentators suggested that
the existing regulations do not work well.
They stated that the current rules provide
little practical guidance upon which an
issuer can rely to determine whether a
broker's fee for a guaranteed investment
contract is a reasonable amount. These
commentators recommended that the safe
harbor be adopted with modifications.
They suggested that the safe harbor will
provide a much needed level of certainty.
The IRS and Treasury Department do
not believe the final regulations will result in tax-exempt bond proceeds being invested in low-yielding, risky investments
because the regulations do not adversely
affect an issuer's incentive to realize investment earnings and to invest in secure
investments. To provide simplicity and
certainty, the final regulations retain the
safe harbor, with certain modifications discussed below. The final regulations do not
limit the amount of brokers' fees that may
be paid by issuers. Thus, for example, the
final regulations do not restrict the ability of an issuer to pay a particular fee that
exceeds the safe harbor amount. Furthermore, brokers' commissions or similar fees
in excess of the safe harbor are qualified
administrative costs if they are reasonable
within the meaning of §1.148–5(e)(2)(i).
B. Per-investment safe harbor
Commentators suggested that, if the
per-investment safe harbor is retained, it
should be increased. These commentators
stated that in some circumstances the safe
harbor does not reflect the value provided
by brokers, particularly in the case of
small or large transactions and long-term
debt service reserve fund investments.

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Suggestions for modifying the per-investment safe harbor included adding a
minimum fee for smaller transactions and
a sliding scale for larger transactions.
Commentators also suggested increasing
the computational base for long-term guaranteed investment contracts by treating
them as a series of shorter-term contracts.
The final regulations increase the
$25,000 amount to $30,000 and provide
for a minimum fee of $3,000. Thus, if
0.2 percent of the computational base is
less than $3,000, the per-investment safe
harbor is $3,000. The final regulations
do not adopt a sliding scale and do not
treat long-term contracts as a series of
shorter-term contracts because the IRS
and Treasury Department have concluded
that the per-investment safe harbor in the
final regulations provides much needed
certainty without requiring issuers to pay
less than fair market value for brokers'
fees.
C. Per-issue safe harbor
Commentators recommended that the
per-issue safe harbor be increased or eliminated. Some commentators suggested replacing the per-issue safe harbor with an
anti-abuse rule to prevent the artificial creation of multiple investments when a single investment would be appropriate. Suggestions included aggregating separate investments that (1) are made at or about the
same time if the bond proceeds being invested have similar rebate or yield characteristics, or (2) would normally be bid together as a single investment unless there
was a good business reason for the separation.
The final regulations retain the per-issue safe harbor and increase the $75,000
amount to $85,000. To maintain simplicity
and certainty, the final regulations do not
adopt the suggestion to replace the per-issue safe harbor with an anti-abuse rule.
The IRS and Treasury Department have
concluded that the per-issue safe harbor in
the final regulations limits artificial separation of investments without requiring issuers to pay less than fair market value for
brokers' fees.
D. Fees in excess of safe harbor
Some commentators requested guidance on the factors for determining
whether a fee in excess of the safe harbor

2003-52 I.R.B.

is reasonable. Suggested factors included
the duration of the contract, the complexity of its terms, the creditworthiness of
the issuer, the availability of providers to
deliver the contract, the presence of unusual features in the issue or the contract,
custom in the industry, and the level of
risk to the broker. The IRS and Treasury
Department have considered the suggested
factors and have concluded that they do
not represent administrable standards for
determining whether a particular fee is reasonable. Therefore, the final regulations
do not specify factors for determining the
reasonableness of fees in excess of the
safe harbor. Under the final regulations,
the determination of whether a fee is
reasonable is made based on all the facts
and circumstances, including whether the
fee satisfies the comparability standard in
§1.148–5(e)(2)(i).
Some commentators suggested that the
portion of a fee that is within the safe harbor should be a qualified administrative
cost, even if the total fee exceeds the safe
harbor. The final regulations adopt this
suggestion.
E. Computational base for guaranteed
investment contracts
Commentators suggested that the computational base for a guaranteed investment contract should be determined as of
the date the contract is acquired, rather
than the issue date, so that the safe harbor
may be applied to guaranteed investment
contracts that are not anticipated on the issue date. The final regulations adopt this
suggestion.
F. Cost-of-living adjustments
Commentators requested that the final
regulations provide for periodic adjustments to the dollar limits in the safe harbor
to reflect inflation. The final regulations
provide a cost-of-living adjustment for
both the per-investment safe harbor and
the per-issue safe harbor. The adjusted
safe harbor dollar amounts will be published in the annual revenue procedure
that sets forth inflation-adjusted items.
G. Interpretative rule
One commentator questioned whether
the proposed regulations should have been

2003-52 I.R.B.

classified as a legislative rule. The IRS and
Treasury Department have reviewed the
applicable authorities and have determined
that the regulations are properly classified
as an interpretative rule.

Adoption of Amendments to the
Regulations

Effective Dates

PART 1—INCOME TAXES

The final regulations apply to bonds
sold on or after February 9, 2004. In
the case of bonds sold before February 9,
2004, that are subject to §1.148–5 (preeffective date bonds), issuers may apply
the final regulations, in whole but not in
part, with respect to transactions entered
into on or after December 11, 2003. If
an issuer applies the final regulations to
pre-effective date bonds, the per-issue safe
harbor is applied by taking into account
all brokers' commissions or similar fees
with respect to guaranteed investment contracts and investments for yield restricted
defeasance escrows that the issuer treats
as qualified administrative costs for the
issue, including all such commissions or
fees paid before February 9, 2004. For
purposes of §§1.148–5(e)(2)(iii)(B)(3) and
1.148–5(e)(2)(iii)(B)(6) of the final regulations (relating to cost-of-living adjustments), transactions entered into before
2003 are treated as entered into in 2003.

Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.148–0 is amended
by revising the entry in paragraph (c) for
§1.148–11 (i) to read as follows:

Accordingly, 26 CFR part 1 is amended
as follows:

§1.148–0 Scope and table of contents.
*****
(c) Table of contents.
*****
§1.148–11 Effective dates.
*****
(i) Special rule for certain broker's commissions and similar fees.
*****
Par. 3. In §1.148–5, paragraph (e) is
amended as follows:
1. Paragraph (e)(2)(iii) is revised.
2. Paragraph (e)(2)(iv) is removed.
The revision reads as follows:

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 has also 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
the rule does not impose a collection of information on small entities, the provisions
of the Regulatory Flexibility Act (5 U.S.C.
chapter 6) do not apply.
Drafting Information
The principal authors of these final regulations are Rose M. Weber and Rebecca
L. Harrigal, Office of Chief Counsel, IRS
(TE/GE), and Stephen J. Watson, Office of
Tax Policy, Treasury Department. However, other personnel from the IRS and
Treasury Department participated in their
development.
*****

1241

§1.148–5 Yield and valuation of
investments.
*****
(e) * * *
(2) * * *
(iii) Special rule for guaranteed investment contracts and investments purchased
for a yield restricted defeasance escrow—(A) In general. An amount paid
for a broker's commission or similar fee
with respect to a guaranteed investment
contract or investments purchased for a
yield restricted defeasance escrow is a
qualified administrative cost if the fee is
reasonable within the meaning of paragraph (e)(2)(i) of this section.
(B) Safe harbor—(1) In general. A
broker's commission or similar fee with
respect to the acquisition of a guaranteed
investment contract or investments purchased for a yield restricted defeasance
escrow is reasonable within the meaning
of paragraph (e)(2)(i) of this section to the
extent that—

December 29, 2003

(i) The amount of the fee that the issuer treats as a qualified administrative
cost does not exceed the lesser of:
(A) $30,000; and
(B) 0.2% of the computational base or,
if more, $3,000; and
(ii) For any issue, the issuer does not
treat as qualified administrative costs more
than $85,000 in brokers' commissions or
similar fees with respect to all guaranteed
investment contracts and investments for
yield restricted defeasance escrows purchased with gross proceeds of the issue.
(2) Computational base. For purposes
of paragraph (e)(2)(iii)(B)(1) of this section, computational base shall mean—
(i) For a guaranteed investment contract, the amount of gross proceeds the
issuer reasonably expects, as of the date
the contract is acquired, to be deposited
in the guaranteed investment contract over
the term of the contract, and
(ii) For investments (other than guaranteed investment contracts) to be deposited
in a yield restricted defeasance escrow, the
amount of gross proceeds initially invested
in those investments.
(3) Cost-of-living adjustment.
In
the case of a calendar year after 2004,
each of the dollar amounts in paragraph
(e)(2)(iii)(B)(1) of this section shall be
increased by an amount equal to—
(i) Such dollar amount; multiplied by
(ii) The cost-of-living adjustment determined under section 1(f)(3) for such calendar year by using the language “calendar
year 2003” instead of “calendar year 1992”
in section 1(f)(3)(B).
(4) Rounding. If any increase determined under paragraph (e)(2)(iii)(B)(3) of
this section is not a multiple of $1,000,
such increase shall be rounded to the nearest multiple thereof.
(5) Applicable year for cost-of-living
adjustment. The cost-of-living adjustments under paragraph (e)(2)(iii)(B)(3) of
this section shall apply to the safe harbor
amounts under paragraph (e)(2)(iii)(B)(1)
of this section based on the year the
guaranteed investment contract or the
investments for the yield restricted defeasance escrow, as applicable, are acquired.
(6) Cost-of-living adjustment to determine remaining amount of per-issue safe
harbor—(i) In general. This paragraph
(e)(2)(iii)(B)(6) applies to determine
the portion of the safe harbor amount
under paragraph (e)(2)(iii)(B)(1)(ii) of

December 29, 2003

this section, as modified by paragraph
(e)(2)(iii)(B)(3) of this section (the per-issue safe harbor), that is available (the
remaining amount) for any year (the determination year) if the per-issue safe harbor
was partially used in one or more prior
years.
(ii) Remaining amount of per-issue safe
harbor. The remaining amount of the perissue safe harbor for any determination
year is equal to the per-issue safe harbor
for that year, reduced by the portion of the
per-issue safe harbor used in one or more
prior years.
(iii) Portion of per-issue safe harbor
used in prior years. The portion of the
per-issue safe harbor used in any prior year
(the prior year) is equal to the total amount
of broker's commissions or similar fees
paid in connection with guaranteed investment contracts or investments for a yield
restricted defeasance escrow acquired in
the prior year that the issuer treated as
qualified administrative costs for the issue,
multiplied by a fraction the numerator of
which is the per-issue safe harbor for the
determination year and the denominator of
which is the per-issue safe harbor for the
prior year. See paragraph (e)(2)(iii)(C) Example 2 of this section.
(C) Examples. The following examples
illustrate the application of the safe harbor
in paragraph (e)(2)(iii)(B) of this section:
Example 1. Multipurpose issue. In 2003, the
issuer of a multipurpose issue uses brokers to acquire the following investments with gross proceeds
of the issue: a guaranteed investment contract for
amounts to be deposited in a construction fund (construction GIC), Treasury securities to be deposited in
a yield restricted defeasance escrow (Treasury investments) and a guaranteed investment contract that will
be used to earn a return on what otherwise would be
idle cash balances from maturing investments in the
yield restricted defeasance escrow (the float GIC).
The issuer deposits $22,000,000 into the construction GIC and reasonably expects that no further deposits will be made over its term. The issuer uses
$8,040,000 of the proceeds to purchase the Treasury
investments. The issuer reasonably expects that it will
make aggregate deposits of $600,000 to the float GIC
over its term. The brokers' fees are $30,000 for the
construction GIC, $16,080 for the Treasury investments and $3,000 for the float GIC. The issuer has
not previously treated any brokers' commissions or
similar fees as qualified administrative costs. The issuer may claim all $49,080 in brokers' fees for these
investments as qualified administrative costs because
the fees do not exceed the safe harbors in paragraph
(e)(2)(iii)(B) of this section. Specifically, each of
the brokers' fees equals the lesser of $30,000 and
0.2% of the computational base (or, if more, $3,000)
(i.e., lesser of $30,000 and 0.2% x $22,000,000 for
the construction GIC; lesser of $30,000 and 0.2% x

1242

$8,040,000 for the Treasury investments; and lesser
of $30,000 and $3,000 for the float GIC). In addition,
the total amount of brokers' fees claimed by the issuer as qualified administrative costs ($49,080) does
not exceed the per-issue safe harbor of $85,000.
Example 2. Cost-of-living adjustment. In 2003,
an issuer issues bonds and uses gross proceeds of the
issue to acquire two guaranteed investment contracts.
The issuer pays a total of $50,000 in brokers' fees
for the two guaranteed investment contracts and
treats these fees as qualified administrative costs.
In a year subsequent to 2003 (Year Y), the issuer
uses gross proceeds of the issue to acquire two
additional guaranteed investment contracts, paying
a total of $20,000 in broker's fees for the two guaranteed investment contracts, and treats those fees as
qualified administrative costs. For Year Y, applying the cost-of-living adjustment under paragraph
(e)(2)(iii)(B)(3) of this section, the safe harbor dollar
limits under paragraph (e)(2)(iii)(B)(1) of this section
are $3,000, $32,000 and $90,000. The remaining
amount of the per-issue safe harbor for Year Y is
$37,059 ($90,000-[$50,000 x $90,000/$85,000]).
The broker's fees in Year Y do not exceed the per-issue safe harbor under paragraph (e)(2)(iii)(B)(1)(ii)
(as modified by paragraph (e)(2)(iii)(B)(3)) of this
section because the broker's fees do not exceed
the remaining amount of the per-issue safe harbor
determined under paragraph (e)(2)(iii)(B)(6) of this
section for Year Y. In a year subsequent to Year Y
(Year Z), the issuer uses gross proceeds of the issue to
acquire an additional guaranteed investment contract,
pays a broker's fee of $15,000 for the guaranteed
investment contract, and treats the broker's fee as
a qualified administrative cost. For Year Z, applying the cost-of-living adjustment under paragraph
(e)(2)(iii)(B)(3) of this section, the safe harbor dollar
limits under paragraph (e)(2)(iii)(B)(1) of this section
are $3,000, $33,000 and $93,000. The remaining
amount of the per-issue safe harbor for Year Z is
$17,627 ($93,000 - [($50,000 x $93,000/$85,000)
+ ($20,000 x $93,000/$90,000)]). The broker's fee
incurred in Year Z does not exceed the per-issue
safe harbor under paragraph (e)(2)(iii)(B)(1)(ii)
(as modified by paragraph (e)(2)(iii)(B)(3)) of this
section because the broker's fee does not exceed
the remaining amount of the per-issue safe harbor
determined under paragraph (e)(2)(iii)(B)(6) of this
section for Year Z. See paragraph (e)(2)(iii)(B)(6) of
this section.

*****
Par. 4. Section 1.148–11 is amended by
revising paragraph (i) to read as follows:
§1.148–11 Effective dates.
*****
(i) Special rule for certain broker's
commissions and similar fees. Section
1.148–5(e)(2)(iii) applies to bonds sold
on or after February 9, 2004. In the
case of bonds sold before February 9,
2004, that are subject to §1.148–5 (pre-effective date bonds), issuers may apply
§1.148–5(e)(2)(iii), in whole but not in
part, with respect to transactions entered

2003-52 I.R.B.

into on or after December 11, 2003. If
an issuer applies §1.148–5(e)(2)(iii) to
pre-effective date bonds, the per-issue safe
harbor in §1.148–5(e)(2)(iii)(B)(1)(ii) is
applied by taking into account all brokers' commissions or similar fees with
respect to guaranteed investment contracts and investments for yield restricted
defeasance escrows that the issuer treats
as qualified administrative costs for the
issue, including all such commissions or
fees paid before February 9, 2004. For
purposes of §§1.148–5(e)(2)(iii)(B)(3)
and 1.148–5(e)(2)(iii)(B)(6) (relating to
cost-of-living adjustments), transactions
entered into before 2003 are treated as
entered into in 2003.
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved December 2, 2003.
Gregory Jenner,
Deputy Assistant Secretary
of the Treasury.
(Filed by the Office of the Federal Register on December 10,
2003, 8:45 a.m., and published in the issue of the Federal
Register for December 11, 2003, 68 F.R. 69020)

Section 165.—Losses
26 CFR 1.165–1: Losses.
(Also § 332; § 1.332–2.)

Worthless security deduction. This
ruling discusses when a shareholder is, and
is not, allowed a worthless security deduction under section 165(g)(3) of the Code
when an election is made to change the
federal tax classification of an entity from
a corporation to a disregarded entity. Rev.
Rul. 70–489 superseded and Rev. Rul.
59–296 amplified.

Rev. Rul. 2003–125
ISSUE
Under the circumstances described below, when an election is made to change
the federal tax classification of an entity
from a corporation to a disregarded entity
under § 301.7701–3 of the Procedure and
Administration Regulations, is the shareholder allowed a worthless security deduction under § 165(g)(3) of the Internal Revenue Code?

2003-52 I.R.B.

FACTS
Situation 1
P is a domestic corporation that is a calendar year taxpayer. FS is an entity that
is organized under the laws of Country X.
FS has only one class of equity interests
outstanding, all of which is owned by P.
Since the date of its organization, FS has
derived all of its gross receipts from manufacturing operations. FS is indebted to P
and to trade creditors. All of FS's indebtedness constitutes valid indebtedness for
federal tax purposes and is recourse to FS.
FS is an eligible entity within the meaning of § 301.7701–3(a) and, prior to July 1,
2003, FS is treated as a corporation within
the meaning of § 7701(a)(3) for federal tax
purposes.
On December 31, 2002, P's FS stock
was not worthless. On July 1, 2003, P
files a valid Form 8832, Entity Classification Election, changing the classification
of FS from a corporation to a disregarded
entity for federal tax purposes effective as
of that date. The election has no effect on
the treatment of FS under Country X law.
After the election is effective, FS continues its manufacturing operations. At the
close of the day immediately before the effective date of the election, the fair market value of FS's assets, including intangible assets such as goodwill and going concern value, exceeds the sum of its liabilities. However, at that time, the fair market
value of FS's assets, excluding intangible
assets such as goodwill and going concern
value, does not exceed the sum of its liabilities.
Situation 2
The facts are the same as in Situation 1,
except that at the close of the day immediately before the effective date of the election, the fair market value of FS's assets,
including intangible assets such as goodwill and going concern value, does not exceed the sum of its liabilities.
LAW AND ANALYSIS
Section 301.7701–3(g)(1)(iii) provides that if an eligible entity classified
as an association properly elects under
§ 301.7701–3(c)(1)(i) to be classified as
a disregarded entity, the association is
deemed to distribute all of its assets and

1243

liabilities to its single owner in liquidation
of the association.
Under § 301.7701–3(g)(2), the tax
treatment of a change in the classification of an entity for federal income tax purposes by an election under
§ 301.7701–3(c)(1)(i) is determined under all relevant provisions of the Internal
Revenue Code and general principles of
tax law, including the step transaction
doctrine.
Section 301.7701–3(g)(3) provides that
any transaction deemed to occur as a result
of a change in classification is treated as
occurring immediately before the close of
the day before the election is effective.
Under § 332(a), no gain or loss shall
be recognized on the receipt by a corporation of property distributed in complete
liquidation of another corporation. Section
332(b) provides, in part, that a distribution shall be considered to be in complete
liquidation only if the corporation receiving such property was, on the date of the
adoption of the plan of liquidation and at
all times thereafter until the receipt of the
property, the owner of stock that meets the
requirements of § 1504(a)(2) and the distribution is made in complete cancellation
or redemption of all of the stock of the liquidating corporation.
Section 1.332–2(b) of the Income Tax
Regulations provides that § 332 applies
only to those cases in which the recipient
corporation receives at least partial payment for stock which it owns in the liquidating corporation. If § 332 is not applicable, see § 165(g) relative to allowance of
losses on worthless securities.
In determining the amount of gain recognized by shareholders upon a taxable
corporate liquidation, courts have recognized that goodwill and other intangible
assets that are distributed in the liquidation must be taken into account. See, e.g.,
Carty v. Commissioner, 38 T.C. 46 (1962).
Section 165(a) allows as a deduction
any loss sustained during the year and not
compensated for by insurance or otherwise. Under § 1.165–1(b) and (d), to be
allowable as a deduction under § 165(a),
a loss must be evidenced by closed and
completed transactions, fixed by identifiable events, and, with certain exceptions,
actually sustained during the taxable year.
Only a bona fide loss is allowable. Substance and not mere form governs in determining a deductible loss.

December 29, 2003