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Bulletin No. 1996–10

March 4, 1996

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.

INCOME TAX

EE–106–82, page 31.

Proposed regulations under section 72 of the Code

relating to loans made from a qualified employer plan

to plan participants or beneficiaries.

Rev. Rul. 96–13, page 19.

Election in respect of losses attributable to a disaster.

This ruling lists the areas declared by the President to

qualify as major disaster areas under the Disaster Relief

and Emergency Assistance Act since the publication of

Rev. Rul. 95–17.

ADMINISTRATIVE

Notice 96–12, page 29.

Mark to market for dealers in securities; related parties

as customers. This notice describes guidance expected

to be issued in proposed regulations concerning

whether a taxpayer’s transactions with related parties,

including members of its consolidated group, may be

transactions with customers for purposes of section

475 of the Code.

T.D. 8648, page 23.

Final regulations under sections 358, 1032, and 1502

of the Code provide rules for adjusting the basis of a

controlling corporation in the stock of a controlled

corporation as the result of certain triangular reorganizations involving the stock of the controlling

corporation.

Notice 96–13, page 29.

Certain payments from the Presidential Election Campaign

Fund. This notice announces a change that will be made

to the Presidential Election Campaign Fund regulations

for certain payments made to Presidential primary

candidates from that Fund.

T.D. 8650, page 5.

Final regulations under section 162 of the Code

relating to the disallowance of deductions for employee

remuneration in excess of $1,000,000.

Finding Lists begin on page 40.

Announcement Relating to Court Decisions, on page 4.

Announcement of Disbarments and Suspensions begins on page 37.

Index for January and February begins on page 42.

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Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

With this in mind, it is the duty of the Service to

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of

view.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

law, to try to find the true meaning of the statutory

provision and not to adopt a strained construction in

the belief that he or she is ‘‘protecting the revenue.’’

The revenue is properly protected only when we ascertain and apply the true meaning of the statute.

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining officers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great courtesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

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Introduction

The Internal Revenue Bulletin is the authoritative

instrument of the Commissioner of Internal Revenue for

announcing official rulings and procedures of the

Internal Revenue Service and for publishing Treasury

Decisions, Executive Orders, Tax Conventions, legislation, court decisions, and other items of general

interest. It is published weekly and may be obtained

from the Superintendent of Documents on a subscription basis. Bulletin contents of a permanent nature are

consolidated semiannually into Cumulative Bulletins,

which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin

all substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published

rulings apply retroactively unless otherwise indicated.

Procedures relating solely to matters of internal

management are not published; however, statements of

internal practices and procedures that affect the rights

and duties of taxpayers are published.

Revenue rulings represent the conclusions of the

Service on the application of the law to the pivotal facts

stated in the revenue ruling. In those based on

positions taken in rulings to taxpayers or technical

advice to Service field offices, identifying details and

information of a confidential nature are deleted to

prevent unwarranted invasions of privacy and to comply

with statutory requirements.

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

Unpublished rulings will not be relied on, used, or cited

as precedents by Service personnel in the disposition of

other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be

considered, and Service personnel and others concerned are cautioned against reaching the same

conclusions in other cases unless the facts and

circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellanous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the

Treasury’s Office of the Assistant Secretary

(Enforcement).

Part IV.—Items of General Interest.

With the exception of the Notice of Proposed Rulemaking and the disbarment and suspension list included in

this part, none of these announcements are consolidated in the Cumulative Bulletins.

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly

and semiannual basis, and are published in the first

Bulletin of the succeeding quarterly and semi-annual

period, respectively.

The Bulletin Index-Digest System, a research and

reference service supplementing the Bulletin, may be

obtained from the Superintendent of Documents on a

subscription basis. It consists of four Services: Service

No. 1, Income Tax; Service No. 2, Estate and Gift

Taxes; Service No. 3, Employment Taxes; Service No.

4, Excise Taxes. Each Service consists of a basic

volume and a cumulative supplement that provides (1)

finding lists of items published in the Bulletin, (2)

digests of revenue rulings, revenue procedures, and

other published items, and (3) indexes of Public Laws,

Treasury Decisions, and Tax Conventions.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

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Announcement Relating to Court Decisions

It is the policy of the Internal

Revenue Service to announce at an

early date whether it will follow the

holdings in certain cases. An Action

on Decision is the document making

such an announcement. An Action

on Decision will be issued at the

discretion of the Service only on

unappealed issues decided adverse

to the government. Generally, an

Action on Decision is issued where

its guidance would be helpful to

Service personnel working with the

same or similar issues. Unlike a

Treasury Regulation or a Revenue

Ruling, an Action on Decision is not

an affirmative statement of Service

position. It is not intended to serve

as public guidance and may not be

cited as precedent.

Actions on Decisions shall be

relied upon within the Service only

as conclusions applying the law to

the facts in the particular case at the

time the Action on Decision was

issued. Caution should be exercised

in extending the recommendation of

the Action on Decision to similar

cases where the facts are different.

Moreover, the recommendation in

the Action on Decision may be

superseded by new legislation, regulations, rulings, cases, or Actions

on Decisions.

Prior to 1991, the Service published acquiescence or nonacquiescence only in certain regular Tax

Court opinions. The Service has

expanded its acquiescence program

to include other civil tax cases where

guidance is determined to be helpful. Accordingly, the Service now

may acquiesce or nonacquiesce in

the holdings of memorandum Tax

Court opinions, as well as those of

the United States District Courts,

Claims Court, and Circuit Courts of

Appeal. Regardless of the court deciding the case, the recommendation

of any Action on Decision will be

published in the Internal Revenue

Bulletin.

The recommendation in every Action on Decision will be summarized

as acquiescence, acquiescence in

result only, or nonacquiescence.

Both ‘‘acquiescence’’ and ‘‘acquiescence in result only’’ mean that the

Service accepts the holding of the

court in a case and that the Service

will follow it in disposing of cases

with the same controlling facts.

However, ‘‘acquiescence’’ indicates

neither approval nor disapproval of

the reasons assigned by the court for

its conclusions; whereas, ‘‘acquiescence in result only’’ indicates disagreement or concern with some or

all of those reasons. Nonacquiescence signifies that, although no

further review was sought, the Service does not agree with the holding

of the court and, generally, will not

follow the decision in disposing of

cases involving other taxpayers. In

reference to an opinion of a circuit

court of appeals, a nonacquiescence

indicates that the Service will not

follow the holding on a nationwide

basis. However, the Service will

recognize the precedential impact of

the opinion on cases arising within

the venue of the deciding circuit.

The announcements published in

the weekly Internal Revenue Bulletins are consolidated semiannually

and annually. The semiannual consolidation appears in the first

Bulletin for July and in the

Cumulative Bulletin for the first half of

the year, and the annual consolidation

appears in the first Bulletin for the

following January and in the Cumulative Bulletin for the last half of the

year.

The Commissioner ACQUIESCE

in the following decisions:

William H. and Patricia Adair v. Commissioner,1 T.C. Memo. 1995 – 493

The Commissioner does NOT ACQUIESCE in the following decisions:

Estate of Goree v. Commissioner,2 T.C.

1994 – 331

Robert B. and Eleanor Risman v.

Commissioner,3 100 T.C. 191 (1993)

Anthony Teong-Chan and Rosanna W.

Gaw v. Commissioner,4 45 F.3d 461

(D.C. Cir. 1995)

1Acquiescence relating to whether petitioner who performed services for the North Atlantic Treaty Organization as a transferee transferred and paid by the U.S.

Department of the Army was entitled to the foreign earned income exclusion under section 911 of the Code.

2Nonacquiescence relating to whether under Estate of Bosch v. Commissioner, 387 U.S. 456 (1967), the Tax Court erred in applying an appellate standard of

review to a lower state court factual determination instead of reviewing the question de novo.

3Nonacquiescence relating to whether a remittance forwarded to the Service with a Form 4868 constitutes a payment of tax or a deposit in the nature of a cash

bond for purposes of the period of limitations for seeking a refund of such remittance.

4Nonacquiescence relating to when the period for filing a Tax Court petition begins to run if the notice of deficiency is mailed to the taxpayers’ last known address

and the Service knows or should know the taxpayers will not receive the noice at their last known address.

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Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 162.—Trade or Business

Expenses

26 CFR 1.162–27: Certain employee

remuneration in excess of $1,000,000.

T.D. 8650

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Disallowance of Deductions for

Employee Remuneration in Excess of

$1,000,000

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to the disallowance of deductions for employee

remuneration in excess of $1,000,000.

The regulations provide guidance to

taxpayers that are subject to section

162(m), which was added to the Code

by the Omnibus Budget Reconciliation

Act of 1993.

DATES: January 1, 1994.

For dates of applicability,

§1.162–27(j).

see

FOR FURTHER INFORMATION

CONTACT: Robert Misner or Charles

T. Deliee at (202) 622-6060 (not a toll

free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545–1466. Responses

to these collections of information are

required to obtain a tax deduction for

performance-based compensation in excess of $1 million.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The estimated average annual burden

per respondent is 50 hours.

Comments concerning the accuracy

of this burden estimate and suggestions

for reducing this burden should be sent

to the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, T:FP,

Washington, DC 20224, and to the

Office of Management and Budget,

Attn: Desk Officer for the Department

of the Treasury, Office of Information

and Regulatory Affairs, Washington,

DC 20503.

Books or records relating to this

collection of information must be retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Background

Under section 162(m) of the Internal

Revenue Code, a publicly held corporation is denied a deduction for compensation paid to its ‘‘covered employees’’

to the extent the compensation exceeds

$1,000,000 if the compensation would

otherwise be deductible in a taxable

year beginning on or after January 1,

1994.

On December 20, 1993, proposed

regulations under section 162(m) (the

1993 proposed regulations) were published in the Federal Register (58 FR

66310 [EE–61–93, 1994–1 C.B. 775]).

Amendments to the proposed regulations (the 1994 amendments) were

published in the Federal Register on

December 2, 1994 (59 FR 61844 [EE–

61–93, 1994–2 C.B. 853]). Public

hearings were held on May 9, 1994,

and August 11, 1995. After consideration of the comments that were received in response to the notices of

proposed rulemaking and at the hearings, the IRS and Treasury adopt the

proposed regulations as amended and

revised by this Treasury decision.

Explanation of Provisions

A. Overview of Provisions

As noted above, section 162(m) provides that a publicly held corporation is

denied a deduction for compensation

paid to a ‘‘covered employee’’ to the

extent the compensation exceeds

$1,000,000. A ‘‘covered employee’’

includes the chief executive officer

(CEO), as well as any other individual

whose compensation is required to be

reported to the Securities and Exchange

Commission by reason of that individual being among the four highest

compensated officers for the taxable

year (other than the CEO), as of the

end of the corporation’s taxable year.

‘‘Performance-based compensation’’

and certain other compensation is not

subject to the deduction limitation of

section 162(m). Performance-based

compensation is remuneration payable

solely on account of the attainment of

one or more performance goals, but

only if: (1) the goals are determined by

a compensation committee of the board

of directors consisting solely of two or

more outside directors; (2) the material

terms under which the compensation is

to be paid are disclosed to the shareholders and approved by a majority in

a separate vote before payment is

made; and (3) before any payment is

made, the compensation committee certifies that the performance goals and

any other material terms have been

satisfied.

Compensation is also excluded from

the deduction limitation of section

162(m) if it is paid under a binding

written contract that was in existence

on February 17, 1993. In addition, in

accordance with the legislative history,

the proposed regulations exempt from

the limitation compensation that is paid

under an arrangement that existed before the corporation became publicly

held, to the extent that the arrangement

is disclosed in the initial public

offering.

B. Discussion of Comments

Comments that relate to the application of the proposed regulations and the

responses to the comments, including

an explanation of the revisions reflected in the final regulations, are

summarized below.

Dividend Equivalents Paid on Stock

Options

Under the proposed regulations, the

performance-based exception to the

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deduction limitation generally is

applied on a grant-by-grant basis. If the

facts and circumstances indicate,

however, that the employee would

receive all or part of the compensation

regardless of whether the performance

goal is attained, the compensation is

not performance based. For example,

where payment under a nonperformance based bonus is contingent upon

the failure to attain the performance

goals under an otherwise performancebased bonus, neither bonus arrangement

will be considered performance based.

The proposed regulations provide that

whether dividends (which generally are

not performance based) on restricted

stock are payable before attainment of

the performance goal, will not affect

the determination of whether the

restricted stock is performance based.

The proposed regulations also provide,

however, that if the amount of any

compensation the employee will

receive under a stock option is not

based solely on an increase in the value

of the stock after the date of grant (for

example, an option granted with an

exercise price that is less than the fair

market value of the stock as of the date

of grant), none of the compensation

attributable to the grant will be

performance based.

Commentators raised the question of

whether nonperformance-based dividend equivalents that are paid with

respect to a granted but unexercised

stock option irrespective of whether the

option is exercised will cause the

compensation paid upon the exercise of

the option to be nonperformance based.

Section 1.162–27(e)(2)(vi) of the final

regulations provides that such dividend

equivalents will not cause the compensation paid upon the exercise of the

option to be nonperformance based,

provided that the payment of the

dividend equivalents is not conditioned

upon the employee exercising the

option. If the payment of the dividend

equivalent is conditioned upon the

employee exercising the option, the

dividend effectively reduces the

exercise price of the option, thereby

causing the option to be nonperformance based upon its exercise.

Bonus Pools

Section 1.162–27(e)(2)(ii) of the

proposed regulations provides that a

preestablished performance goal must

state, in terms of an objective formula

or standard, the method for computing

the amount of compensation payable to

the employee if the goal is attained. A

formula or standard is objective if a

third party having knowledge of the

relevant performance results could

calculate the amount to be paid to the

employee.

Section 1.162–27(e)(2)(iii) prohibits

discretion to increase the amount of

compensation to be paid under the

preestablished performance goal, but

permits the compensation committee to

reduce or eliminate the compensation

that is due upon attainment of the goal.

Examples 7 and 8 under §1.162–27(e)(2)(vii) of the proposed regulations

illustrated the application of these rules

to bonus pools. In Example 7, the

amount of the bonus pool was determined under an objective formula.

However, because the compensation

committee retained the discretion to

determine the fraction of the bonus

pool that each covered employee would

receive, the compensation that any

individual could receive was not

determined under an objective formula

and, therefore, the bonus plan did not

satisfy the requirements of paragraph

(e)(2). In Example 8, the compensation

for any individual was determined

under an objective formula because

each employee’s share of the bonus

pool was specified and because,

notwithstanding the compensation

committee’s ability to reduce the

compensation payable to each individual employee, a reduction in one

employee’s bonus would not result in

an increase in the amount of any other

employee’s bonus.

Several commentators have indicated

that, in some cases where compensation

committees have stated the amount

payable to each individual under a

bonus pool plan as a percentage of the

bonus pool, the total of these

percentages has exceeded 100 percent

of the pool. The use of such overlapping percentages is inconsistent with

§1.162–27(e)(2), as illustrated by both

Example 7 and Example 8. As noted,

Example 8 states that negative discretion will not cause the bonus plan to

fail to satisfy the requirements of

paragraph (e)(2), ‘‘provided that a

reduction in the amount of one employee’s bonus does not result in an

increase in the amount of any other

employee’s bonus.’’ Where the total of

the percentages payable under a bonus

pool plan exceeds 100 percent, it is

impossible to award each individual the

stated percentage, and this necessary

exercise of negative discretion with

respect to one or more employees

means that it is impossible for a third

party, with knowledge of the relevant

performance results, to calculate the

amount to be paid to each employee.

Further, a reduction in at least some

employees’ bonuses will result in an

increase in the amount available to pay

other employees’ bonuses.

Accordingly, §1.162–27(e)(2)(iii) is

amended to state more clearly that,

when the compensation to be paid to

each employee is stated in terms of a

percentage of a bonus pool, the sum of

the individual percentages for all

participants in the pool cannot exceed

100 percent. In addition, the principle

stated in Example 8, that the exercise

of negative discretion with respect to

one employee cannot increase the

amount payable to another employee, is

incorporated in paragraph (e)(2)(iii).

Example 8 is also revised to more

clearly illustrate this rule.

Although the IRS and Treasury believe that the changes made merely

clarify the proposed regulations, it is

recognized that others have interpreted

the language of the proposed regulations differently. Therefore, under

§1.162–27(j)(2)(iv), this clarified rule

will not be applied to any compensation paid before January 1, 2001, under

a bonus pool based on performance in

any period that began before December

20, 1995.

Outside Directors

Section 1.162–27(e)(3)(vi) provides

that a director is not precluded from

being an outside director solely because

he or she is a former officer of a

corporation that previously was an

affiliated corporation of the publicly

held corporation. The regulation is

revised to clarify that a former officer

of either a spun off or liquidated

corporation, that formerly was a

member of the affiliated group, is not

precluded from serving on the compensation committee of the publicly

held member of the affiliated group.

Companies that Become Publicly

Held Without an Initial Public

Offering

Under §1.162–27(f), the $1 million

deduction limit does not apply to any

compensation plan or agreement that

existed before the corporation became

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publicly held to the extent that the plan

or agreement was disclosed in the

prospectus accompanying the initial

public offering (IPO). This exception

may be relied on until the earliest of:

(1) the expiration of the plan or

agreement, (2) the material modification of the plan or agreement, (3) the

issuance of all stock and other compensation that has been allocated under the

plan, or (4) the first shareholder meeting at which directors will be elected

that occurs after the close of the third

calendar year following the calendar

year in which the IPO occurs.

Commentators have asked whether

this rule applies to corporations that

become publicly held without an IPO.

As indicated in the legislative history

accompanying Code section 162(m),

the prospectus that accompanies the

IPO provides an opportunity to disclose

the terms of the plan or agreement to

the potential shareholders, and the

subsequent purchase of the stock with

that knowledge may be viewed as tantamount to a favorable vote on the

compensation arrangement. When a

corporation becomes publicly held

without an IPO, there is no comparable

alternative means of satisfying the

requirements of section 162(m)(4)(C)(ii). On the other hand, because there is

no requirement for privately held corporations to comply with section

162(m), the IRS and Treasury recognize the need for a transition rule for

plans and agreements that are in

existence when a privately held corporation becomes publicly held without

an IPO.

Accordingly, §1.162–27(f)(1) is revised to provide relief for privately

held corporations that become publicly

held without an IPO. Under the transition rule for these corporations, the

reliance period in §1.162–27(f)(2)

lapses upon the first meeting of shareholders at which directors are to be

elected that occurs after the close of

the first calendar year following the

calendar year in which the corporation

becomes publicly held.

Written Binding Contracts

Section 1.162–27(h)(1) provides the

transition rules for compensation payable under a written binding contract

that was in effect on February 17,

1993. Under those rules, a written

binding contract that is terminable or

cancelable by the corporation after

February 17, 1993, without the

employee’s consent is treated as a new

contract as of the date that any such

termination or cancelation, if made,

would be effective. The proposed regulations further provide that, if the

terms of a contract provide that the

contract will be terminated or canceled

as of a certain date unless either the

corporation or the employee elects to

renew within 30 days of that date, the

contract is treated as renewed by the

corporation as of that date.

Commentators have suggested that

these regulations clarify the outcome

where a corporation will remain bound

by the terms of a contract beyond a

certain date at the sole discretion of the

employee. For example, if a contract

that is in effect on February 17, 1993,

provides that the employee has the sole

discretion to extend or renew the terms

beyond its stated expiration, without

the consent of the corporation, a

question arises whether the contract

will be considered a pre-February 17,

1993 written binding contract after the

employee chooses to extend.

Generally, the question of whether

the terms of a contract are binding is

determined under state law. The IRS

and Treasury believe that the rules for

determining whether a contract is binding should be applied based on whether

the corporation is bound by the terms

of the contract. Thus, if a contract

provides the employee with the right to

extend or renew its terms without the

consent of the corporation, and the

corporation is legally obligated to pay

the agreed-upon compensation to the

employee if the employee chooses to

extend or renew the contract, the

contract will be considered binding on

the corporation. Accordingly, a new

sentence has been added to §1.162–

27(h)(1)(i) to clarify that, if the corporation will remain legally obligated by

the terms of a contract beyond a certain

date at the sole discretion of the employee, the contract will not be treated

as a new contract as of that date if the

employee exercises the discretion.

Awards Based on a Percentage of

Salary

The 1994 amendments modified

§1.162–27(e)(2)(iii) to provide that, if

the terms of an objective formula or

standard fail to preclude discretion

merely because the amount of compensation to be paid upon attainment of

the performance goal is based, in whole

or in part, on a percentage of salary or

base pay, the objective formula or

standard will not be considered discretionary (and thus §1.162–27(e)(2)(iii)

will not be violated) if the maximum

dollar amount to be paid is fixed at the

time the performance goal is established. The final regulations clarify that

a maximum dollar amount need not be

specified under this provision if, at the

time the performance goal is established, the dollar amount of salary or

base pay is fixed. In such a case, the

use of salary or base pay does not

cause the formula to fail to preclude

discretion to increase compensation.

The 1994 amendments made a corresponding amendment with respect to

salary-based formulas to the shareholder disclosure rules in §1.162–

27(e)(4)(i). However, the shareholder

disclosure amendment was not explicitly limited to formulas that would

otherwise be discretionary. The final

regulations clarify that the shareholder

disclosure rule relating to salary-based

formulas applies only to those formulas

that would otherwise be discretionary.

In addition, the final regulations

provide transition relief with respect to

the 1994 amendment of the shareholder

disclosure requirement relating to

salary-based formulas. New §1.162–27(j)(2)(v) provides that this disclosure

requirement applies only to plans approved by shareholders after April 30,

1995.

In the case of a preestablished

performance goal that was established

prior to the publication of the 1994

amendments, a corporation could, of

course, rely upon a reasonable good

faith interpretation of the statutory

provisions to determine that the performance goal was stated in terms of

an objective formula, to the extent the

issue to which the interpretation relates

was not covered by the 1993 regulations. An award made pursuant to such

a performance goal would not fail to be

performance based merely because the

award was made after the publication

of the 1994 amendments.

Stock-Based Compensation

The 1993 proposed regulations provided transition relief for previously

approved plans and agreements that did

not satisfy the written binding contract

requirement as of February 17, 1993,

but that were approved by shareholders

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before December 20, 1993. See

§1.162–27(h)(3)(iii). The transition relief applied to compensation paid prior

to the expiration of a reliance period.

In response to comments on the 1993

proposed regulations, the 1994 amendments expanded this relief to encompass compensation paid after the reliance period with respect to the

exercise of stock options and stock

appreciation rights, and the substantial

vesting of restricted property, provided

that the stock option, stock appreciation

right, or restricted property was granted

during the reliance period. Similar

relief provisions were also included in

new transition rules added by the 1994

amendments. (See §§1.162–27(f)(3),

(f)(4), (j)(2)(ii), and (j)(2)(iii) of the

final regulations.)

Commentators have asked that the

relief provided in the 1994 amendments

for stock options, stock appreciation

rights, and restricted property be extended even further to cover other

stock-based compensation and deferred

compensation in general. After careful

consideration of the comments received, the IRS and Treasury have

concluded that there is not adequate

justification for a further expansion of

the 1994 expansion of the prior regulatory transition relief for previously

approved plans and agreements, or the

other similar relief provisions added in

1994.

Subsidiaries That Become Separate

Publicly Held Corporations

Section 1.162–27(f)(4) of the proposed regulations contains special rules

for subsidiaries that become separate

publicly held corporations. A transition

rule set forth in §1.162–27(i)(2)(iii) of

the proposed regulations specified delayed effective dates for these special

rules. However, commentators indicated that the regulation were not

explicit as to which rules applied prior

to the delayed effective dates.

The final regulations clarify that

compensation paid prior to the delayed

effective dates by a subsidiary that

becomes a separate publicly held corporation will not be subject to the $1

million deduction limit if the conditions

of the transition rule are satisfied. (This

transition rule and all other effective

date provisions have been moved from

paragraph (i) to paragraph (j) of the

final regulations. Paragraph (i) is

reserved.)

Special Analysis

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

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) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not

apply to these regulations, and, therefore, a Regulatory Flexibility Analysis

is not required. Pursuant to section

7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking

preceding these regulations was submitted to the Small Business Administration for comment on its impact on

small business.

Drafting Information

The principal authors of these regulations are Charles T. Deliee and

Robert Misner, Office of the Associate

Chief Counsel (Employee Benefits and

Exempt Organizations), Internal Revenue Service. However, other personnel

from IRS and the Treasury Department

participated in their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1 and

602 are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority for part 1

continues to read in part as follows:

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

Par. 2. Section 1.162–27 is added to

read as follows:

§1.162–27 Certain employee

remuneration in excess of $1,000,000

(a) Scope. This section provides

rules for the application of the $1

million deduction limit under section

162(m) of the Internal Revenue Code.

Paragraph (b) of this section provides

the general rule limiting deductions

under section 162(m). Paragraph (c) of

this section provides definitions of

generally applicable terms. Paragraph

(d) of this section provides an exception from the deduction limit for

compensation payable on a commission

basis. Paragraph (e) of this section

provides an exception for qualified

performance-based compensation. Paragraphs (f) and (g) of this section

provide special rules for corporations

that become publicly held corporations

and payments that are subject to

section 280G, respectively. Paragraph

(h) of this section provides transition

rules, including the rules for contracts

that are grandfathered and not subject

to section 162(m). Paragraph (j) of this

section contains the effective date provisions. For rules concerning the deductibility of compensation for services

that are not covered by section 162(m)

and this section, see section 162(a)(1)

and §1.162–7. This section is not

determinative as to whether compensation meets the requirements of section

162(a)(1).

(b) Limitation on deduction. Section

162(m) precludes a deduction under

chapter 1 of the Internal Revenue Code

by any publicly held corporation for

compensation paid to any covered

employee to the extent that the compensation for the taxable year exceeds

$1,000,000.

corporation—(i) General rule. A publicly held corporation means any corporation issuing any class of common

equity securities required to be registered under section 12 of the Exchange

Act. A corporation is not considered

publicly held if the registration of its

equity securities is voluntary. For purposes of this section, whether a corporation is publicly held is determined

based solely on whether, as of the last

day of its taxable year, the corporation

is subject to the reporting obligations

of section 12 of the Exchange Act.

(ii) Affiliated groups. A publicly

held corporation includes an affiliated

group of corporations, as defined in

section 1504 (determined without regard to section 1504(b)). For purposes

of this section, however, an affiliated

group of corporations does not include

any subsidiary that is itself a publicly

held corporation. Such a publicly held

subsidiary, and its subsidiaries (if any),

are separately subject to this section. If

a covered employee is paid compensation in a taxable year by more than one

member of an affiliated group, compensation paid by each member of the

affiliated group is aggregated with

compensation paid to the covered

employee by all other members of the

group. Any amount disallowed as a

deduction by this section must be

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prorated among the payor corporations

in proportion to the amount of compensation paid to the covered employee by

each such corporation in the taxable

year.

(2) Covered employee—(i) General

rule. A covered employee means any

individual who, on the last day of the

taxable year, is—

(A) The chief executive officer of

the corporation or is acting in such

capacity; or

(B) Among the four highest compensated officers (other than the chief

executive officer).

(ii) Application of rules of the Securities and Exchange Commission.

Whether an individual is the chief

executive officer described in paragraph (c)(2)(i)(A) of this section or an

officer described in paragraph

(c)(2)(i)(B) of this section is determined pursuant to the executive compensation disclosure rules under the

Exchange Act.

(3) Compensation—(i) In general.

For purposes of the deduction limitation described in paragraph (b) of this

section, compensation means the aggregate amount allowable as a deduction

under chapter 1 of the Internal Revenue

Code for the taxable year (determined

without regard to section 162(m)) for

remuneration for services performed by

a covered employee, whether or not the

services were performed during the

taxable year.

(ii) Exceptions. Compensation does

not include—

(A) Remuneration covered in section

3121(a)(1) through section 3121(a)(5)(D) (concerning remuneration that is

not treated as wages for purposes of

the Federal Insurance Contributions

Act); and

(B) Remuneration consisting of any

benefit provided to or on behalf of an

employee if, at the time the benefit is

provided, it is reasonable to believe

that the employee will be able to

exclude it from gross income. In

addition, compensation does not include salary reduction contributions

described in section 3121(v)(1).

(4) Compensation Committee. The

compensation committee means the

committee of directors (including any

subcommittee of directors) of the publicly held corporation that has the

authority to establish and administer

performance goals described in paragraph (e)(2) of this section, and to

certify that performance goals are

attained, as described in paragraph

(e)(5) of this section. A committee of

directors is not treated as failing to

have the authority to establish performance goals merely because the goals

are ratified by the board of directors of

the publicly held corporation or, if

applicable, any other committee of the

board of directors. See paragraph (e)(3)

of this section for rules concerning the

composition of the compensation committee.

(5) Exchange Act. The Exchange Act

means the Securities Exchange Act of

1934.

(6) Examples. This paragraph (c)

may be illustrated by the following

examples:

Example 1. Corporation X is a publicly held

corporation with a July 1 to June 30 fiscal year.

For Corporation X’s taxable year ending on June

30, 1995, Corporation X pays compensation of

$2,000,000 to A, an employee. However, A’s

compensation is not required to be reported to

shareholders under the executive compensation

disclosure rules of the Exchange Act because A

is neither the chief executive officer nor one of

the four highest compensated officers employed

on the last day of the taxable year. A’s

compensation is not subject to the deduction

limitation of paragraph (b) of this section.

Example 2. C, a covered employee, performs

services and receives compensation from Corporations X, Y, and Z, members of an affiliated

group of corporations. Corporation X, the parent

corporation, is a publicly held corporation. The

total compensation paid to C from all affiliated

group members is $3,000,000 for the taxable

year, of which Corporation X pays $1,500,000;

Corporation Y pays $900,000; and Corporation Z

pays $600,000. Because the compensation paid

by all affiliated group members is aggregated for

purposes of section 162(m), $2,000,000 of the

aggregate compensation paid is nondeductible.

Corporations X, Y, and Z each are treated as

paying a ratable portion of the nondeductible

compensation. Thus, two thirds of each corporation’s payment will be nondeductible. Corporation X has a nondeductible compensation expense of $1,000,000 ($1,500,000 3

$2,000,000/$3,000,000). Corporation Y has a

nondeductible compensation expense of $600,000

($900,000 3 $2,000,000/$3,000,000). Corporation Z has a nondeductible compensation expense

of $400,000 ($600,000 3 $2,000,000/

$3,000,000).

Example 3. Corporation W, a calendar year

taxpayer, has total assets equal to or exceeding

$5 million and a class of equity security held of

record by 500 or more persons on December 31,

1994. However, under the Exchange Act, Corporation W is not required to file a registration

statement with respect to that security until April

30, 1995. Thus, Corporation W is not a publicly

held corporation on December 31, 1994, but is a

publicly held corporation on December 31, 1995.

Example 4. The facts are the same as in

Example 3, except that on December 15, 1996,

Corporation W files with the Securities and

Exchange Commission to disclose that Corporation W is no longer required to be registered

under section 12 of the Exchange Act and to

terminate its registration of securities under that

provision. Because Corporation W is no longer

subject to Exchange Act reporting obligations as

of December 31, 1996, Corporation W is not a

publicly held corporation for taxable year 1996,

even though the registration of Corporation W’s

securities does not terminate until 90 days after

Corporation W files with the Securities and

Exchange Commission.

(d) Exception for compensation paid

on a commission basis. The deduction

limit in paragraph (b) of this section

shall not apply to any compensation

paid on a commission basis. For this

purpose, compensation is paid on a

commission basis if the facts and

circumstances show that it is paid

solely on account of income generated

directly by the individual performance

of the individual to whom the compensation is paid. Compensation does not

fail to be attributable directly to the

individual merely because support services, such as secretarial or research

services, are utilized in generating the

income. However, if compensation is

paid on account of broader performance standards, such as income produced by a business unit of the

corporation, the compensation does not

qualify for the exception provided

under this paragraph (d).

(e) Exception for qualified

performance-based compensation—

(1) In general. The deduction limit

in paragraph (b) of this section does

not apply to qualified performancebased compensation. Qualified performance-based compensation is compensation that meets all of the requirements of paragraphs (e)(2) through

(e)(5) of this section.

(2) Performance goal requirement—

(i) Preestablished goal. Qualified

performance-based compensation must

be paid solely on account of the

attainment of one or more preestablished, objective performance

goals. A performance goal is considered preestablished if it is established

in writing by the compensation committee not later than 90 days after the

commencement of the period of service

to which the performance goal relates,

provided that the outcome is substantially uncertain at the time the compensation committee actually establishes

the goal. However, in no event will a

performance goal be considered to be

preestablished if it is established after

25 percent of the period of service (as

scheduled in good faith at the time the

goal is established) has elapsed. A

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performance goal is objective if a third

party having knowledge of the relevant

facts could determine whether the goal

is met. Performance goals can be based

on one or more business criteria that

apply to the individual, a business unit,

or the corporation as a whole. Such

business criteria could include, for

example, stock price, market share,

sales, earnings per share, return on

equity, or costs. A performance goal

need not, however, be based upon an

increase or positive result under a

business criterion and could include,

for example, maintaining the status quo

or limiting economic losses (measured,

in each case, by reference to a specific

business criterion). A performance goal

does not include the mere continued

employment of the covered employee.

Thus, a vesting provision based solely

on continued employment would not

constitute a performance goal. See

paragraph (e)(2)(vi) of this section for

rules on compensation that is based on

an increase in the price of stock.

(ii) Objective compensation formula.

A preestablished performance goal

must state, in terms of an objective

formula or standard, the method for

computing the amount of compensation

payable to the employee if the goal is

attained. A formula or standard is

objective if a third party having knowledge of the relevant performance results could calculate the amount to be

paid to the employee. In addition, a

formula or standard must specify the

individual employees or class of

employees to which it applies.

(iii) Discretion.

(A) The terms of an objective formula or standard must preclude discretion to increase the amount of compensation payable that would otherwise be

due upon attainment of the goal. A

performance goal is not discretionary

for purposes of this paragraph

(e)(2)(iii) merely because the compensation committee reduces or eliminates

the compensation or other economic

benefit that was due upon attainment of

the goal. However, the exercise of

negative discretion with respect to one

employee is not permitted to result in

an increase in the amount payable to

another employee. Thus, for example,

in the case of a bonus pool, if the

amount payable to each employee is

stated in terms of a percentage of the

pool, the sum of these individual

percentages of the pool is not permitted

to exceed 100 percent. If the terms of

an objective formula or standard fail to

preclude discretion to increase the

amount of compensation merely because the amount of compensation to

be paid upon attainment of the performance goal is based, in whole or in

part, on a percentage of salary or base

pay and the dollar amount of the salary

or base pay is not fixed at the time the

performance goal is established, then

the objective formula or standard will

not be considered discretionary for

purposes of this paragraph (e)(2)(iii) if

the maximum dollar amount to be paid

is fixed at that time.

(B) If compensation is payable upon

or after the attainment of a performance goal, and a change is made to

accelerate the payment of compensation

to an earlier date after the attainment of

the goal, the change will be treated as

an increase in the amount of compensation, unless the amount of compensation paid is discounted to reasonably

reflect the time value of money. If

compensation is payable upon or after

the attainment of a performance goal,

and a change is made to defer the

payment of compensation to a later

date, any amount paid in excess of the

amount that was originally owed to the

employee will not be treated as an

increase in the amount of compensation

if the additional amount is based either

on a reasonable rate of interest or on

one or more predetermined actual

investments (whether or not assets

associated with the amount originally

owed are actually invested therein)

such that the amount payable by the

employer at the later date will be based

on the actual rate of return of a specific

investment (including any decrease as

well as any increase in the value of an

investment). If compensation is payable

in the form of property, a change in the

timing of the transfer of that property

after the attainment of the goal will not

be treated as an increase in the amount

of compensation for purposes of this

paragraph (e)(2)(iii). Thus, for example, if the terms of a stock grant

provide for stock to be transferred after

the attainment of a performance goal

and the transfer of the stock also is

subject to a vesting schedule, a change

in the vesting schedule that either

accelerates or defers the transfer of

stock will not be treated as an increase

in the amount of compensation payable

under the performance goal.

stock option, stock appreciation right,

or other stock-based compensation does

not fail to satisfy the requirements of

this paragraph (e)(2) to the extent that

a change in the grant or award is made

to reflect a change in corporate capitalization, such as a stock split or

dividend, or a corporate transaction,

such as any merger of a corporation

into another corporation, any consolidation of two or more corporations into

another corporation, any separation of a

corporation (including a spinoff or

other distribution of stock or property

by a corporation), any reorganization of

a corporation (whether or not such

reorganization comes within the definition of such term in section 368), or

any partial or complete liquidation by a

corporation.

(iv) Grant-by-grant determination.

The determination of whether compensation satisfies the requirements of this

paragraph (e)(2) generally shall be

made on a grant-by-grant basis. Thus,

for example, whether compensation

attributable to a stock option grant

satisfies the requirements of this paragraph (e)(2) generally is determined on

the basis of the particular grant made

and without regard to the terms of any

other option grant, or other grant of

compensation, to the same or another

employee. As a further example, except

as provided in paragraph (e)(2)(vi),

whether a grant of restricted stock or

other stock-based compensation satisfies the requirements of this paragraph

(e)(2) is determined without regard to

whether dividends, dividend equivalents, or other similar distributions with

respect to stock, on such stock-based

compensation are payable prior to the

attainment of the performance goal.

Dividends, dividend equivalents, or

other similar distributions with respect

to stock that are treated as separate

grants under this paragraph (e)(2)(iv)

are not performance-based compensation unless they separately satisfy the

requirements of this paragraph (e)(2).

(v) Compensation contingent upon

attainment of performance goal. Compensation does not satisfy the requirements of this paragraph (e)(2) if the

facts and circumstances indicate that

the employee would receive all or part

of the compensation regardless of

whether the performance goal is attained. Thus, if the payment of compensation under a grant or award is

only nominally or partially contingent

on attaining a performance goal, none

of the compensation payable under the

grant or award will be considered

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performance-based. For example, if an

employee is entitled to a bonus under

either of two arrangements, where

payment under a nonperformance-based

arrangement is contingent upon the

failure to attain the performance goals

under an otherwise performance-based

arrangement, then neither arrangement

provides for compensation that satisfies

the requirements of this paragraph

(e)(2). Compensation does not fail to

be qualified performance-based compensation merely because the plan

allows the compensation to be payable

upon death, disability, or change of

ownership or control, although compensation actually paid on account of those

events prior to the attainment of the

performance goal would not satisfy the

requirements of this paragraph (e)(2).

As an exception to the general rule set

forth in the first sentence of paragraph

(e)(2)(iv) of this section, the facts-andcircumstances determination referred to

in the first sentence of this paragraph

(e)(2)(v) is made taking into account

all plans, arrangements, and agreements

that provide for compensation to the

employee.

(vi) Application of requirements to

stock options and stock appreciation

rights—(A) In general. Compensation

attributable to a stock option or a stock

appreciation right is deemed to satisfy

the requirements of this paragraph

(e)(2) if the grant or award is made by

the compensation committee; the plan

under which the option or right is

granted states the maximum number of

shares with respect to which options or

rights may be granted during a specified period to any employee; and,

under the terms of the option or right,

the amount of compensation the employee could receive is based solely on

an increase in the value of the stock

after the date of the grant or award.

Conversely, if the amount of compensation the employee will receive under

the grant or award is not based solely

on an increase in the value of the stock

after the date of grant or award (e.g., in

the case of restricted stock, or an

option that is granted with an exercise

price that is less than the fair market

value of the stock as of the date of

grant), none of the compensation attributable to the grant or award is

qualified performance-based compensation because it does not satisfy the

requirement of this paragraph (e)(2)(vi)(A). Whether a stock option grant is

based solely on an increase in the value

of the stock after the date of grant is

determined without regard to any dividend equivalent that may be payable,

provided that payment of the dividend

equivalent is not made contingent on

the exercise of the option. The rule that

the compensation attributable to a stock

option or stock appreciation right must

be based solely on an increase in the

value of the stock after the date of

grant or award does not apply if the

grant or award is made on account of,

or if the vesting or exercisability of the

grant or award is contingent on, the

attainment of a performance goal that

satisfies the requirements of this paragraph (e)(2).

(B) Cancellation and repricing.

Compensation attributable to a stock

option or stock appreciation right does

not satisfy the requirements of this

paragraph (e)(2) to the extent that the

number of options granted exceeds the

maximum number of shares for which

options may be granted to the employee as specified in the plan. If an

option is canceled, the canceled option

continues to be counted against the

maximum number of shares for which

options may be granted to the employee under the plan. If, after grant,

the exercise price of an option is

reduced, the transaction is treated as a

cancellation of the option and a grant

of a new option. In such case, both the

option that is deemed to be canceled

and the option that is deemed to be

granted reduce the maximum number

of shares for which options may be

granted to the employee under the plan.

This paragraph (e)(2)(vi)(B) also applies in the case of a stock appreciation

right where, after the award is made,

the base amount on which stock appreciation is calculated is reduced to

reflect a reduction in the fair market

value of stock.

(vii) Examples. This paragraph (e)(2)

may be illustrated by the following

examples:

Example 1. No later than 90 days after the

start of a fiscal year, but while the outcome is

substantially uncertain, Corporation S establishes

a bonus plan under which A, the chief executive

officer, will receive a cash bonus of $500,000, if

year-end corporate sales are increased by at least

5 percent. The compensation committee retains

the right, if the performance goal is met, to

reduce the bonus payment to A if, in its

judgment, other subjective factors warrant a

reduction. The bonus will meet the requirements

of this paragraph (e)(2).

Example 2. The facts are the same as in

Example 1, except that the bonus is based on a

percentage of Corporation S’s total sales for the

fiscal year. Because Corporation S is virtually

certain to have some sales for the fiscal year, the

outcome of the performance goal is not substantially uncertain, and therefore the bonus does not

meet the requirements of this paragraph (e)(2).

Example 3. The facts are the same as in

Example 1, except that the bonus is based on a

percentage of Corporation S’s total profits for the

fiscal year. Although some sales are virtually

certain for virtually all public companies, it is

substantially uncertain whether a company will

have profits for a specified future period even if

the company has a history of profitability.

Therefore, the bonus will meet the requirements

of this paragraph (e)(2).

Example 4. B is the general counsel of

Corporation R, which is engaged in patent

litigation with Corporation S. Representatives of

Corporation S have informally indicated to

Corporation R a willingness to settle the

litigation for $50,000,000. Subsequently, the

compensation committee of Corporation R agrees

to pay B a bonus if B obtains a formal settlement

for at least $50,000,000. The bonus to B does

not meet the requirement of this paragraph (e)(2)

because the performance goal was not established at a time when the outcome was

substantially uncertain.

Example 5. Corporation S, a public utility,

adopts a bonus plan for selected salaried

employees that will pay a bonus at the end of a

3-year period of $750,000 each if, at the end of

the 3 years, the price of S stock has increased by

10 percent. The plan also provides that the 10percent goal will automatically adjust upward or

downward by the percentage change in a published utilities index. Thus, for example, if the

published utilities index shows a net increase of

5 percent over a 3-year period, then the salaried

employees would receive a bonus only if

Corporation S stock has increased by 15 percent.

Conversely, if the published utilities index shows

a net decrease of 5 percent over a 3-year period,

then the salaried employees would receive a

bonus if Corporation S stock has increased by 5

percent. Because these automatic adjustments in

the performance goal are preestablished, the

bonus meets the requirement of this paragraph

(e)(2), notwithstanding the potential changes in

the performance goal.

Example 6. The facts are the same as in

Example 5, except that the bonus plan provides

that, at the end of the 3-year period, a bonus of

$750,000 will be paid to each salaried employee

if either the price of Corporation S stock has

increased by 10 percent or the earnings per share

on Corporation S stock have increased by 5

percent. If both the earnings-per-share goal and

the stock-price goal are preestablished, the

compensation committee’s discretion to choose

to pay a bonus under either of the two goals does

not cause any bonus paid under the plan to fail

to meet the requirement of this paragraph (e)(2)

because each goal independently meets the requirements of this paragraph (e)(2). The choice

to pay under either of the two goals is

tantamount to the discretion to choose not to pay

under one of the goals, as provided in paragraph

(e)(2)(iii) of this section.

Example 7. Corporation U establishes a bonus

plan under which a specified class of employees

will participate in a bonus pool if certain

preestablished performance goals are attained.

The amount of the bonus pool is determined

under an objective formula. Under the terms of

the bonus plan, the compensation committee

retains the discretion to determine the fraction of

the bonus pool that each employee may receive.

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The bonus plan does not satisfy the requirements

of this paragraph (e)(2). Although the aggregate

amount of the bonus plan is determined under an

objective formula, a third party could not

determine the amount that any individual could

receive under the plan.

Example 8. The facts are the same as in

Example 7, except that the bonus plan provides

that a specified share of the bonus pool is

payable to each employee, and the total of these

shares does not exceed 100% of the pool. The

bonus plan satisfies the requirements of this

paragraph (e)(2). In addition, the bonus plan will

satisfy the requirements of this paragraph (e)(2)

even if the compensation committee retains the

discretion to reduce the compensation payable to

any individual employee, provided that a reduction in the amount of one employee’s bonus does

not result in an increase in the amount of any

other employee’s bonus.

Example 9. Corporation V establishes a stock

option plan for salaried employees. The terms of

the stock option plan specify that no salaried

employee shall receive options for more than

100,000 shares over any 3-year period. The

compensation committee grants options for

50,000 shares to each of several salaried

employees. The exercise price of each option is

equal to or greater than the fair market value at

the time of each grant. Compensation attributable

to the exercise of the options satisfies the

requirements of this paragraph (e)(2). If, however, the terms of the options provide that the

exercise price is less than fair market value at

the date of grant, no compensation attributable to

the exercise of those options satisfies the

requirements of this paragraph (e)(2) unless

issuance or exercise of the options was contingent upon the attainment of a preestablished

performance goal that satisfies this paragraph

(e)(2).

Example 10. The facts are the same as in

Example 9, except that, within the same 3-year

grant period, the fair market value of Corporation V stock is significantly less than the

exercise price of the options. The compensation

committee reprices those options to that lower

current fair market value of Corporation V stock.

The repricing of the options for 50,000 shares

held by each salaried employee is treated as the

grant of new options for an additional 50,000

shares to each employee. Thus, each of the

salaried employees is treated as having received

grants for 100,000 shares. Consequently, if any

additional options are granted to those employees

during the 3-year period, compensation attributable to the exercise of those additional options

would not satisfy the requirements of this

paragraph (e)(2). The results would be the same

if the compensation committee canceled the

outstanding options and issued new options to

the same employees that were exercisable at the

fair market value of Corporation V stock on the

date of reissue.

Example 11. Corporation W maintains a plan

under which each participating employee may

receive incentive stock options, nonqualified

stock options, stock appreciation rights, or grants

of restricted Corporation W stock. The plan

specifies that each participating employee may

receive options, stock appreciation rights,

restricted stock, or any combination of each, for

no more than 20,000 shares over the life of the

plan. The plan provides that stock options may

be granted with an exercise price of less than,

equal to, or greater than fair market value on the

date of grant. Options granted with an exercise

price equal to, or greater than, fair market value

on the date of grant do not fail to meet the

requirements of this paragraph (e)(2) merely

because the compensation committee has the

discretion to determine the types of awards (i.e.,

options, rights, or restricted stock) to be granted

to each employee or the discretion to issue

options or make other compensation awards

under the plan that would not meet the requirements of this paragraph (e)(2). Whether an

option granted under the plan satisfies the

requirements of this paragraph (e)(2) is determined on the basis of the specific terms of the

option and without regard to other options or

awards under the plan.

Example 12. Corporation X maintains a plan

under which stock appreciation rights may be

awarded to key employees. The plan permits the

compensation committee to make awards under

which the amount of compensation payable to

the employee is equal to the increase in the stock

price plus a percentage ‘‘gross up’’ intended to

offset the tax liability of the employee. In

addition, the plan permits the compensation

committee to make awards under which the

amount of compensation payable to the employee

is equal to the increase in the stock price, based

on the highest price, which is defined as the

highest price paid for Corporation X stock (or

offered in a tender offer or other arms-length

offer) during the 90 days preceding exercise.

Compensation attributable to awards under the

plan satisfies the requirements of paragraph

(e)(2)(vi) of this section, provided that the terms

of the plan specify the maximum number of

shares for which awards may be made.

Example 13. Corporation W adopts a plan

under which a bonus will be paid to the CEO

only if there is a 10% increase in earnings per

share during the performance period. The plan

provides that earnings per share will be calculated without regard to any change in accounting

standards that may be required by the Financial

Accounting Standards Board after the goal is

established. After the goal is established, such a

change in accounting standards occurs. Corporation W’s reported earnings, for purposes of

determining earnings per share under the plan,

are adjusted pursuant to this plan provision to

factor out this change in standards. This adjustment will not be considered an exercise of

impermissible discretion because it is made

pursuant to the plan provision.

Example 14. Corporation X adopts a

performance-based incentive pay plan with a

four-year performance period. Bonuses under the

plan are scheduled to be paid in the first year

after the end of the performance period (year 5).

However, in the second year of the performance

period, the compensation committee determines

that any bonuses payable in year 5 will instead,

for bona fide business reasons, be paid in year

10. The compensation committee also determines

that any compensation that would have been

payable in year 5 will be adjusted to reflect the

delay in payment. The adjustment will be based

on the greater of the future rate of return of a

specified mutual fund that invests in blue chip

stocks or of a specified venture capital investment over the five-year deferral period. Each of

these investments, considered by itself, is a

predetermined actual investment because it is

based on the future rate of return of an actual

investment. However, the adjustment in this case

is not based on predetermined actual investments

within the meaning of paragraph (e)(2)(iii)(B) of

this section because the amount payable by

Corporation X in year 10 will be based on the

greater of the two investment returns and, thus,

will not be based on the actual rate of return on

either specific investment.

Example 15. The facts are the same as in

Example 14, except that the increase will be

based on Moody’s Average Corporate Bond

Yield over the five-year deferral period. Because

this index reflects a reasonable rate of interest,

the increase in the compensation payable that is

based on the index’s rate of return is not considered an impermissible increase in the amount

of compensation payable under the formula.

Example 16. The facts are the same as in

Example 14, except that the increase will be

based on the rate of return for the Standard &

Poor’s 500 Index. This index does not measure

interest rates and thus does not represent a

reasonable rate of interest. In addition, this index

does not represent an actual investment. Therefore, any additional compensation payable based

on the rate of return of this index will result in

an impermissible increase in the amount payable

under the formula. If, in contrast, the increase

were based on the rate of return of an existing

mutual fund that is invested in a manner that

seeks to approximate the Standard & Poor’s 500

Index, the increase would be based on a predetermined actual investment within the meaning

of paragraph (e)(2)(iii)(B) of this section and

thus would not result in an impermissible

increase in the amount payable under the

formula.

(3) Outside directors—(i) General

rule. The performance goal under

which compensation is paid must be

established by a compensation committee comprised solely of two or more

outside directors. A director is an

outside director if the director—

(A) Is not a current employee of the

publicly held corporation;

(B) Is not a former employee of the

publicly held corporation who receives

compensation for prior services (other

than benefits under a tax-qualified

retirement plan) during the taxable

year;

publicly held corporation; and

(D) Does not receive remuneration

from the publicly held corporation,

either directly or indirectly, in any

capacity other than as a director. For

this purpose, remuneration includes any

payment in exchange for goods or

services.

(ii) Remuneration received. For purposes of this paragraph (e)(3), remuneration is received, directly or

indirectly, by a director in each of the

following circumstances:

(A) If remuneration is paid, directly

or indirectly, to the director personally

or to an entity in which the director has

a beneficial ownership interest of

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greater than 50 percent. For this

purpose, remuneration is considered

paid when actually paid (and throughout the remainder of that taxable year

of the corporation) and, if earlier,

throughout the period when a contract

or agreement to pay remuneration is

outstanding.

(B) If remuneration, other than de

minimis remuneration, was paid by the

publicly held corporation in its preceding taxable year to an entity in which

the director has a beneficial ownership

interest of at least 5 percent but not

more than 50 percent. For this purpose,

remuneration is considered paid when

actually paid or, if earlier, when the

publicly held corporation becomes liable to pay it.

minimis remuneration, was paid by the

publicly held corporation in its preceding taxable year to an entity by which

the director is employed or selfemployed other than as a director. For

this purpose, remuneration is considered paid when actually paid or, if

earlier, when the publicly held corporation becomes liable to pay it.

(iii) De minimis remuneration—(A)

In general. For purposes of paragraphs

(e)(3)(ii)(B) and (C) of this section,

remuneration that was paid by the

publicly held corporation in its preceding taxable year to an entity is de

minimis if payments to the entity did

not exceed 5 percent of the gross

revenue of the entity for its taxable

year ending with or within that preceding taxable year of the publicly held

corporation.

(B) Remuneration for personal services and substantial owners. Notwithstanding paragraph (e)(3)(iii)(A) of this

section, remuneration in excess of

$60,000 is not de minimis if the

remuneration is paid to an entity

described in paragraph (e)(3)(ii)(B) of

this section, or is paid for personal

services to an entity described in

paragraph (e)(3)(ii)(C) of this section.

(iv) Remuneration for personal services. For purposes of paragraph (e)(3)(iii)(B) of this section, remuneration

from a publicly held corporation is for

personal services if—

(A) The remuneration is paid to an

entity for personal or professional

services, consisting of legal, accounting, investment banking, and management consulting services (and other

similar services that may be specified

by the Commissioner in revenue rul-

ings, notices, or other guidance published in the Internal Revenue Bulletin), performed for the publicly held

corporation, and the remuneration is

not for services that are incidental to

the purchase of goods or to the

purchase of services that are not

personal services; and

(B) The director performs significant

services (whether or not as an employee) for the corporation, division, or

similar organization (within the entity)

that actually provides the services

described in paragraph (e)(3)(iv)(A) of

this section to the publicly held corporation, or more than 50 percent of the

entity’s gross revenues (for the entity’s

preceding taxable year) are derived

from that corporation, subsidiary, or

similar organization.

(v) Entity defined. For purposes of

this paragraph (e)(3), entity means an

organization that is a sole proprietorship, trust, estate, partnership, or corporation. The term also includes an affiliated group of corporations as defined in section 1504 (determined

without regard to section 1504(b)) and

a group of organizations that would be

an affiliated group but for the fact that

one or more of the organizations are

not incorporated. However, the aggregation rules referred to in the

preceding sentence do not apply for

purposes of determining whether a

director has a beneficial ownership

interest of at least 5 percent or greater

than 50 percent.

(vi) Employees and former officers.

Whether a director is an employee or a

former officer is determined on the

basis of the facts at the time that the

individual is serving as a director on

the compensation committee. Thus, a

director is not precluded from being an

outside director solely because the

director is a former officer of a

corporation that previously was an

affiliated corporation of the publicly

held corporation. For example, a director of a parent corporation of an affiliated group is not precluded from

being an outside director solely because

that director is a former officer of an

affiliated subsidiary that was spun off

or liquidated. However, an outside

director would no longer be an outside

director if a corporation in which the

director was previously an officer

became an affiliated corporation of the

publicly held corporation.

(vii) Officer. Solely for purposes of

this paragraph (e)(3), officer means an

administrative executive who is or was

in regular and continued service. The

term implies continuity of service and

excludes those employed for a special

and single transaction. An individual

who merely has (or had) the title of

officer but not the authority of an

officer is not considered an officer. The

determination of whether an individual

is or was an officer is based on all the

of facts and circumstances in the

particular case, including without limitation the source of the individual’s

authority, the term for which the

individual is elected or appointed, and

the nature and extent of the individual’s duties.

(viii) Members of affiliated groups.

For purposes of this paragraph (e)(3),

the outside directors of the publicly

held member of an affiliated group are

treated as the outside directors of all

members of the affiliated group.

(ix) Examples. This paragraph (e)(3)

may be illustrated by the following

examples:

Example 1. Corporations X and Y are members of an affiliated group of corporations as

defined in section 1504, until July 1, 1994, when

Y is sold to another group. Prior to the sale, A

served as an officer of Corporation Y. After July

1, 1994, A is not treated as a former officer of

Corporation X by reason of having been an

officer of Y.

Example 2. Corporation Z, a calendar-year

taxpayer, uses the services of a law firm by

which B is employed, but in which B has a lessthan-5-percent ownership interest. The law firm

reports income on a July 1 to June 30 basis.

Corporation Z appoints B to serve on its

compensation committee for calendar year 1998

after determining that, in calendar year 1997, it

did not become liable to the law firm for

remuneration exceeding the lesser of $60,000 or

five percent of the law firm’s gross revenue

(calculated for the year ending June 30, 1997).

On October 1, 1998, Corporation Z becomes

liable to pay remuneration of $50,000 to the law

firm on June 30, 1999. For the year ending June

30, 1998, the law firm’s gross revenue was less

than $1 million. Thus, in calendar year 1999, B

is not an outside director. However, B may

satisfy the requirements for an outside director in

calendar year 2000, if, in calendar year 1999,

Corporation Z does not become liable to the law

firm for additional remuneration. This is because

the remuneration actually paid on June 30, 1999

was considered paid on October 1, 1998 under

paragraph (e)(3)(ii)(C) of this section.

Example 3. Corporation Z, a publicly held

corporation, purchases goods from Corporation

A. D, an executive and less-than-5-percent owner

of Corporation A, sits on the board of directors

of Corporation Z and on its compensation committee. For 1997, Corporation Z obtains representations to the effect that D is not eligible for

any commission for D’s sales to Corporation Z

and that, for purposes of determining D’s

compensation for 1997, Corporation A’s sales to

Corporation Z are not otherwise treated dif-

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ferently than sales to other customers of Corporation A (including its affiliates, if any) or are

irrelevant. In addition, Corporation Z has no

reason to believe that these representations are

inaccurate or that it is otherwise paying remuneration indirectly to D personally. Thus, in

1997, no remuneration is considered paid by

Corporation Z indirectly to D personally under

paragraph (e)(3)(ii)(A) of this section.

Example 4. (i) Corporation W, a publicly held

corporation, purchases goods from Corporation

T. C, an executive and less-than-5-percent owner

of Corporation T, sits on the board of directors

of Corporation W and on its compensation committee. Corporation T develops a new product

and agrees on January 1, 1998 to pay C a bonus

of $500,000 if Corporation W contracts to

purchase the product. Even if Corporation W

purchases the new product, sales to Corporation

W will represent less than 5 percent of

Corporation T’s gross revenues. In 1999, Corporation W contracts to purchase the new product

and, in 2000, C receives the $500,000 bonus

from Corporation T. In 1998, 1999, and 2000,

Corporation W does not obtain any representations relating to indirect remuneration to C

personally (such as the representations described

in Example 3).

(ii) Thus, in 1998, 1999, and 2000, remuneration is considered paid by Corporation W

indirectly to C personally under paragraph

(e)(3)(ii)(A) of this section. Accordingly, in

1998, 1999, and 2000, C is not an outside

director of Corporation W. The result would

have been the same if Corporation W had obtained appropriate representations but nevertheless had reason to believe that it was paying

remuneration indirectly to C personally.

Example 5. Corporation R, a publicly held

corporation, purchases utility service from Corporation Q, a public utility. The chief executive

officer, and less-than-5-percent owner, of Corporation Q is a director of Corporation R.

Corporation R pays Corporation Q more than

$60,000 per year for the utility service, but less

than 5 percent of Corporation Q’s gross revenues. Because utility services are not personal

services, the fees paid are not subject to the

$60,000 de minimis rule for remuneration for

personal services within the meaning of paragraph (e)(3)(iii)(B) of this section. Thus, the

chief executive officer qualifies as an outside

director of Corporation R, unless disqualified on

some other basis.

Example 6. Corporation A, a publicly held

corporation, purchases management consulting

services from Division S of Conglomerate P. The

chief financial officer of Division S is a director

of Corporation A. Corporation A pays more than

$60,000 per year for the management consulting

services, but less than 5 percent of Conglomerate

P’s gross revenues. Because management consulting services are personal services within the

meaning of paragraph (e)(3)(iv)(A) of this

section, and the chief financial officer performs

significant services for Division S, the fees paid

are subject to the $60,000 de minimis rule as

remuneration for personal services. Thus, the

chief financial officer does not qualify as an

outside director of Corporation A.

Example 7. The facts are the same as in

Example 6, except that the chief executive

officer, and less-than-5-percent owner, of the

parent company of Conglomerate P is a director

of Corporation A and does not perform significant services for Division S. If the gross

revenues of Division S do not constitute more

than 50 percent of the gross revenues of

Conglomerate P for P’s preceding taxable year,

the chief executive officer will qualify as an

outside director of Corporation A, unless disqualified on some other basis.

(4) Shareholder approval requirement—(i) General rule. The material

terms of the performance goal under

which the compensation is to be paid

must be disclosed to and subsequently

approved by the shareholders of the

publicly held corporation before the

compensation is paid. The requirements

of this paragraph (e)(4) are not satisfied

if the compensation would be paid

regardless of whether the material

terms are approved by shareholders.

The material terms include the

employees eligible to receive compensation; a description of the business

criteria on which the performance goal

is based; and either the maximum

amount of compensation that could be

paid to any employee or the formula

used to calculate the amount of compensation to be paid to the employee if

the performance goal is attained (except that, in the case of a formula that

fails to preclude discretion to increase

the amount of compensation (as described in paragraph (e)(2)(iii)(A) of

this section) merely because the

amount of compensation to be paid is

based, in whole or in part, on a

percentage of salary or base pay and

the dollar amount of the salary or base

pay is not fixed at the time the

performance goal is established, the

maximum dollar amount of compensation that could be paid to the employee

must be disclosed).

(ii) Eligible employees. Disclosure of

the employees eligible to receive compensation need not be so specific as to

identify the particular individuals by

name. A general description of the

class of eligible employees by title or

class is sufficient, such as the chief

executive officer and vice presidents,

or all salaried employees, all executive

officers, or all key employees.

(iii) Description of business

criteria—(A) In general. Disclosure of

the business criteria on which the

performance goal is based need not

include the specific targets that must be

satisfied under the performance goal.

For example, if a bonus plan provides

that a bonus will be paid if earnings

per share increase by 10 percent, the

10-percent figure is a target that need

not be disclosed to shareholders. However, in that case, disclosure must be

made that the bonus plan is based on

an earnings-per-share business criterion. In the case of a plan under which

employees may be granted stock options or stock appreciation rights, no

specific description of the business

criteria is required if the grants or

awards are based on a stock price that

is no less than current fair market

value.

(B) Disclosure of confidential information. The requirements of this paragraph (e)(4) may be satisfied even

though information that otherwise

would be a material term of a performance goal is not disclosed to shareholders, provided that the compensation

committee determines that the information is confidential commercial or

business information, the disclosure of

which would have an adverse effect on

the publicly held corporation. Whether

disclosure would adversely affect the

corporation is determined on the basis

of the facts and circumstances. If the

compensation committee makes such a

determination, the disclosure to shareholders must state the compensation

committee’s belief that the information

is confidential commercial or business

information, the disclosure of which

would adversely affect the company. In

addition, the ability not to disclose

confidential information does not eliminate the requirement that disclosure be

made of the maximum amount of

compensation that is payable to an

individual under a performance goal.

Confidential information does not include the identity of an executive or

the class of executives to which a

performance goal applies or the amount

of compensation that is payable if the

goal is satisfied.

(iv) Description of compensation.

Disclosure as to the compensation

payable under a performance goal must

be specific enough so that shareholders

can determine the maximum amount of

compensation that could be paid to any

employee during a specified period. If

the terms of the performance goal do

not provide for a maximum dollar

amount, the disclosure must include the

formula under which the compensation

would be calculated. Thus, for example, if compensation attributable to the

exercise of stock options is equal to the

difference in the exercise price and the

current value of the stock, disclosure

would be required of the maximum

number of shares for which grants may

be made to any employee and the

exercise price of those options (e.g.,

fair market value on date of grant). In

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that case, shareholders could calculate

the maximum amount of compensation

that would be attributable to the

exercise of options on the basis of their

assumptions as to the future stock

price.

(v) Disclosure requirements of the

Securities and Exchange Commission.

To the extent not otherwise specifically

provided in this paragraph (e)(4),

whether the material terms of a performance goal are adequately disclosed

to shareholders is determined under the

same standards as apply under the

Exchange Act.

(vi) Frequency of disclosure. Once

the material terms of a performance

goal are disclosed to and approved by

shareholders, no additional disclosure

or approval is required unless the

compensation committee changes the

material terms of the performance goal.

If, however, the compensation committee has authority to change the targets

under a performance goal after shareholder approval of the goal, material

terms of the performance goal must be

disclosed to and reapproved by shareholders no later than the first shareholder meeting that occurs in the fifth

year following the year in which

shareholders previously approved the

performance goal.

(vii) Shareholder vote. For purposes

of this paragraph (e)(4), the material

terms of a performance goal are approved by shareholders if, in a separate

vote, a majority of the votes cast on the

issue (including abstentions to the

extent abstentions are counted as voting

under applicable state law) are cast in

favor of approval.

(viii) Members of affiliated group.

For purposes of this paragraph (e)(4),

the shareholders of the publicly held

member of the affiliated group are

treated as the shareholders of all

members of the affiliated group.

(ix) Examples. This paragraph (e)(4)

may be illustrated by the following

examples:

Example 1. Corporation X adopts a plan that

will pay a specified class of its executives an

annual cash bonus based on the overall increase

in corporate sales during the year. Under the

terms of the plan, the cash bonus of each

executive equals $100,000 multiplied by the

number of percentage points by which sales

increase in the current year when compared to

the prior year. Corporation X discloses to its

shareholders prior to the vote both the class of

executives eligible to receive awards and the

annual formula of $100,000 multiplied by the

percentage increase in sales. This disclosure

meets the requirements of this paragraph (e)(4).

Because the compensation committee does not

have the authority to establish a different target

under the plan, Corporation X need not redisclose to its shareholders and obtain their

reapproval of the material terms of the plan until

those material terms are changed.

Example 2. The facts are the same as in

Example 1 except that Corporation X discloses

only that bonuses will be paid on the basis of the

annual increase in sales. This disclosure does not

meet the requirements of this paragraph (e)(4)

because it does not include the formula for

calculating the compensation or a maximum

amount of compensation to be paid if the

performance goal is satisfied.

Example 3. Corporation Y adopts an incentive

compensation plan in 1995 that will pay a

specified class of its executives a bonus every 3

years based on the following 3 factors: increases

in earnings per share, reduction in costs for

specified divisions, and increases in sales by

specified divisions. The bonus is payable in cash

or in Corporation Y stock, at the option of the

executive. Under the terms of the plan, prior to

the beginning of each 3-year period, the compensation committee determines the specific targets

under each of the three factors (i.e., the amount

of the increase in earnings per share, the

reduction in costs, and the amount of sales) that

must be met in order for the executives to

receive a bonus. Under the terms of the plan, the

compensation committee retains the discretion to

determine whether a bonus will be paid under

any one of the goals. The terms of the plan also

specify that no executive may receive a bonus in

excess of $1,500,000 for any 3-year period. To

satisfy the requirements of this paragraph (e)(4),

Corporation Y obtains shareholder approval of

the plan at its 1995 annual shareholder meeting.

In the proxy statement issued to shareholders,

Corporation Y need not disclose to shareholders

the specific targets that are set by the compensation committee. However, Corporation Y must

disclose that bonuses are paid on the basis of

earnings per share, reductions in costs, and

increases in sales of specified divisions. Corporation Y also must disclose the maximum amount

of compensation that any executive may receive

under the plan is $1,500,000 per 3-year period.

Unless changes in the material terms of the plan

are made earlier, Corporation Y need not

disclose the material terms of the plan to the

shareholders and obtain their reapproval until the

first shareholders’ meeting held in 2000.

Example 4. The same facts as in Example 3,

except that prior to the beginning of the second

3-year period, the compensation committee determines that different targets will be set under the

plan for that period with regard to all three of

the performance criteria (i.e., earnings per share,

reductions in costs, and increases in sales). In

addition, the compensation committee raises the

maximum dollar amount that can be paid under

the plan for a 3-year period to $2,000,000. The

increase in the maximum dollar amount of

compensation under the plan is a changed

material term. Thus, to satisfy the requirements

of this paragraph (e)(4), Corporation Y must

disclose to and obtain approval by the shareholders of the plan as amended.

Example 5. In 1998, Corporation Z establishes

a plan under which a specified group of

executives will receive a cash bonus not to

exceed $750,000 each if a new product that has

been in development is completed and ready for

sale to customers by January 1, 2000. Although

the completion of the new product is a material

term of the performance goal under this paragraph (e)(4), the compensation committee determines that the disclosure to shareholders of the

performance goal would adversely affect Corporation Z because its competitors would be made

aware of the existence and timing of its new

product. In this case, the requirements of this

paragraph (e)(4) are satisfied if all other material

terms, including the maximum amount of compensation, are disclosed and the disclosure

affirmatively states that the terms of the performance goal are not being disclosed because the

compensation committee has determined that

those terms include confidential information, the

disclosure of which would adversely affect

Corporation Z.

(5) Compensation committee certification. The compensation committee

must certify in writing prior to payment

of the compensation that the performance goals and any other material terms

were in fact satisfied. For this purpose,

approved minutes of the compensation

committee meeting in which the certification is made are treated as a

written certification. Certification by

the compensation committee is not

required for compensation that is attributable solely to the increase in the

stock of the publicly held corporation.

(f) Companies that become publicly

held, spinoffs, and similar transactions—(1) In general. In the case of

a corporation that was not a publicly

held corporation and then becomes a

publicly held corporation, the deduction

limit of paragraph (b) of this section

does not apply to any remuneration

paid pursuant to a compensation plan

or agreement that existed during the

period in which the corporation was

not publicly held. However, in the case

of such a corporation that becomes

publicly held in connection with an

initial public offering, this relief applies

only to the extent that the prospectus

accompanying the initial public offering disclosed information concerning

those plans or agreements that satisfied

all applicable securities laws then in

effect. In accordance with paragraph

(c)(1)(ii) of this section, a corporation

that is a member of an affiliated group

that includes a publicly held corporation is considered publicly held and,

therefore, cannot rely on this paragraph

(f)(1).

(2) Reliance period. Paragraph (f)(1)

of this section may be relied upon until

the earliest of—

(i) The expiration of the plan or

agreement;

(ii) The material modification of the

plan or agreement, within the meaning

of paragraph (h)(1)(iii) of this section;

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(iii) The issuance of all employer

stock and other compensation that has

been allocated under the plan; or

(iv) The first meeting of shareholders at which directors are to be

elected that occurs after the close of

the third calendar year following the

calendar year in which the initial public

offering occurs or, in the case of a

privately held corporation that becomes

publicly held without an initial public

offering, the first calendar year following the calendar year in which the

corporation becomes publicly held.

(3) Stock-based compensation. Paragraph (f)(1) of this section will apply

to any compensation received pursuant

to the exercise of a stock option or

stock appreciation right, or the substantial vesting of restricted property,

granted under a plan or agreement

described in paragraph (f)(1) of this

section if the grant occurs on or before

the earliest of the events specified in

paragraph (f)(2) of this section.

(4) Subsidiaries that become separate publicly held corporations—(i) In

general. If a subsidiary that is a

member of the affiliated group described in paragraph (c)(1)(ii) of this

section becomes a separate publicly

held corporation (whether by spinoff or

otherwise), any remuneration paid to

covered employees of the new publicly

held corporation will satisfy the exception for performance-based compensation described in paragraph (e) of this

section if the conditions in either

paragraph (f)(4)(ii) or (f)(4)(iii) of this

section are satisfied.

(ii) Prior establishment and approval. Remuneration satisfies the requirements of this paragraph (f)(4)(ii) if

the remuneration satisfies the requirements for performance-based compensation set forth in paragraphs (e)(2),

(e)(3), and (e)(4) of this section (by

application of paragraphs (e)(3)(viii)

and (e)(4)(viii) of this section) before

the corporation becomes a separate

publicly held corporation, and the

certification required by paragraph

(e)(5) of this section is made by the

compensation committee of the new

publicly held corporation (but if the

performance goals are attained before

the corporation becomes a separate

publicly held corporation, the certification may be made by the compensation

committee referred to in paragraph

(e)(3)(viii) of this section before it

becomes a separate publicly held corporation). Thus, this paragraph (f)(4)(ii)

requires that the outside directors and

shareholders (within the meaning of

paragraphs (e)(3)(viii) and (e)(4)(viii)

of this section) of the corporation

before it becomes a separate publicly

held corporation establish and approve,

respectively, the performance-based

compensation for the covered employees of the new publicly held

corporation in accordance with paragraphs (e)(3) and (e)(4) of this section.

(iii) Transition period. Remuneration

satisfies the requirements of this paragraph (f)(4)(iii) if the remuneration

satisfies all of the requirements of

paragraphs (e)(2), (e)(3), and (e)(5) of

this section. The outside directors

(within the meaning of paragraph

(e)(3)(viii) of this section) of the

corporation before it becomes a separate publicly held corporation, or the

outside directors of the new publicly

held corporation, may establish and

administer the performance goals for

the covered employees of the new

publicly held corporation for purposes

of satisfying the requirements of paragraphs (e)(2) and (e)(3) of this section.

The certification required by paragraph

(e)(5) of this section must be made by

the compensation committee of the new

publicly held corporation. However, a

taxpayer may rely on this paragraph

(f)(4)(iii) to satisfy the requirements of

paragraph (e) of this section only for

compensation paid, or stock options,

stock appreciation rights, or restricted

property granted, prior to the first

regularly scheduled meeting of the

shareholders of the new publicly held

corporation that occurs more than 12

months after the date the corporation

becomes a separate publicly held corporation. Compensation paid, or stock

options, stock appreciation rights, or

restricted property granted, on or after

the date of that meeting of shareholders

must satisfy all requirements of paragraph (e) of this section, including the

shareholder approval requirement of

paragraph (e)(4) of this section, in

order to satisfy the requirements for

performance-based compensation.

(5) Example. The following example

illustrates the application of paragraph

(f)(4)(ii) of this section:

Example. Corporation P, which is publicly

held, decides to spin off Corporation S, a wholly

owned subsidiary of Corporation P. After the

spinoff, Corporation S will be a separate publicly

held corporation. Before the spinoff, the compensation committee of Corporation P, pursuant to

paragraph (e)(3)(viii) of this section, establishes

a bonus plan for the executives of Corporation S

that provides for bonuses payable after the

spinoff and that satisfies the requirements of

paragraph (e)(2) of this section. If, pursuant to

paragraph (e)(4)(viii) of this section, the shareholders of Corporation P approve the plan prior

to the spinoff, that approval will satisfy the

requirements of paragraph (e)(4) of this section

with respect to compensation paid pursuant to

the bonus plan after the spinoff. However, the

compensation committee of Corporation S will

be required to certify that the goals are satisfied

prior to the payment of the bonuses in order for

the bonuses to be considered performance-based

compensation.

(g) Coordination with disallowed excess parachute payments . The

$1,000,000 limitation in paragraph (b)

of this section is reduced (but not

below zero) by the amount (if any) that

would have been included in the

compensation of the covered employee

for the taxable year but for being

disallowed by reason of section 280G.

For example, assume that during a

taxable year a corporation pays

$1,500,000 to a covered employee and

no portion satisfies the exception in

paragraph (d) of this section for commissions or paragraph (e) of this

section for qualified performance-based

compensation. Of the $1,500,000,

$600,000 is an excess parachute payment, as defined in section 280G(b)(1)

and is disallowed by reason of that

section. Because the excess parachute

payment reduces the limitation of paragraph (b) of this section, the corporation can deduct $400,000, and

$500,000 of the otherwise deductible

amount is nondeductible by reason of

section 162(m).

(h) Transition rules—(1) Compensation payable under a written binding

contract which was in effect on February 17, 1993—(i) General rule. The

deduction limit of paragraph (b) of this

section does not apply to any compensation payable under a written binding

contract that was in effect on February

17, 1993. The preceding sentence does

not apply unless, under applicable state

law, the corporation is obligated to pay

the compensation if the employee performs services. However, the deduction

limit of paragraph (b) of this section

does apply to a contract that is renewed

after February 17, 1993. A written

binding contract that is terminable or

cancelable by the corporation after

February 17, 1993, without the

employee’s consent is treated as a new

contract as of the date that any such

termination or cancellation, if made,

would be effective. Thus, for example,

if the terms of a contract provide that it

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will be automatically renewed as of a

certain date unless either the corporation or the employee gives notice of

termination of the contract at least 30

days before that date, the contract is

treated as a new contract as of the date

that termination would be effective if

that notice were given. Similarly, for

example, if the terms of a contract

provide that the contract will be

terminated or canceled as of a certain

date unless either the corporation or the

employee elects to renew within 30

days of that date, the contract is treated

as renewed by the corporation as of

that date. Alternatively, if the corporation will remain legally obligated by

the terms of a contract beyond a certain

date at the sole discretion of the

employee, the contract will not be

treated as a new contract as of that date

if the employee exercises the discretion

to keep the corporation bound to the

contract. A contract is not treated as

terminable or cancelable if it can be

terminated or canceled only by terminating the employment relationship of

the employee.

(ii) Compensation payable under a

plan or arrangement. If a compensation

plan or arrangement meets the requirements of paragraph (h)(1)(i) of this

section, the compensation paid to an

employee pursuant to the plan or

arrangement will not be subject to the

deduction limit of paragraph (b) of this

section even though the employee was

not eligible to participate in the plan as

of February 17, 1993. However, the

preceding sentence does not apply

unless the employee was employed on

February 17, 1993, by the corporation

that maintained the plan or arrangement, or the employee had the right to

participate in the plan or arrangement

under a written binding contract as of

that date.

(iii) Material modifications.

(A) Paragraph (h)(1)(i) of this section will not apply to any written

binding contract that is materially

modified. A material modification occurs when the contract is amended to

increase the amount of compensation

payable to the employee. If a binding

written contract is materially modified,

it is treated as a new contract entered

into as of the date of the material

modification. Thus, amounts received

by an employee under the contract

prior to a material modification are not

affected, but amounts received subsequent to the material modification are

not treated as paid under a binding,

written contract described in paragraph

(h)(1)(i) of this section.

(B) A modification of the contract

that accelerates the payment of compensation will be treated as a material

modification unless the amount of

compensation paid is discounted to

reasonably reflect the time value of

money. If the contract is modified to

defer the payment of compensation,

any compensation paid in excess of the

amount that was originally payable to

the employee under the contract will

not be treated as a material modification if the additional amount is based

on either a reasonable rate of interest

or one or more predetermined actual

investments (whether or not assets

associated with the amount originally

owed are actually invested therein)

such that the amount payable by the

employer at the later date will be based

on the actual rate of return of the

specific investment (including any decrease as well as any increase in the

value of the investment).

contract or agreement that provides for

increased compensation, or the payment

of additional compensation, is a material modification of a binding, written

contract where the facts and circumstances show that the additional compensation is paid on the basis of

substantially the same elements or

conditions as the compensation that is

otherwise paid under the written binding contract. However, a material modification of a written binding contract

does not include a supplemental payment that is equal to or less than a

reasonable cost-of-living increase over

the payment made in the preceding

year under that written binding contract. In addition, a supplemental payment of compensation that satisfies the

requirements of qualified performancebased compensation in paragraph (e) of

this section will not be treated as a

material modification.

(iv) Examples. The following examples illustrate the exception of this

paragraph (h)(1):

Example 1. Corporation X executed a 3-year

compensation arrangement with C on February

15, 1993, that constitutes a written binding

contract under applicable state law. The terms of

the arrangement provide for automatic extension

after the 3-year term for additional 1-year

periods, unless the corporation exercises its

option to terminate the arrangement within 30

days of the end of the 3-year term or, thereafter,

within 30 days before each anniversary date.

Termination of the compensation arrangement

does not require the termination of C’s employment relationship with Corporation X. Unless

terminated, the arrangement is treated as renewed

on February 15, 1996, and the deduction limit of

paragraph (b) of this section applies to payments

under the arrangement after that date.

Example 2. Corporation Y executed a 5-year

employment agreement with B on January 1,

1992, providing for a salary of $900,000 per

year. Assume that this agreement constitutes a

written binding contract under applicable state

law. In 1992 and 1993, B receives the salary of

$900,000 per year. In 1994, Corporation Y

increases B’s salary with a payment of $20,000.

The $20,000 supplemental payment does not

constitute a material modification of the written

binding contract because the $20,000 payment is

less than or equal to a reasonable cost-of-living

increase from 1993. However, the $20,000

supplemental payment is subject to the limitation

in paragraph (b) of this section. On January 1,

1995, Corporation Y increases B’s salary to

$1,200,000. The $280,000 supplemental payment

is a material modification of the written binding

contract because the additional compensation is

paid on the basis of substantially the same

elements or conditions as the compensation that

is otherwise paid under the written binding

contract and it is greater than a reasonable,

annual cost-of-living increase. Because the written binding contract is materially modified as of

January 1, 1995, all compensation paid to B in

1995 and thereafter is subject to the deduction

limitation of section 162(m).

Example 3. Assume the same facts as in

Example 2, except that instead of an increase in

salary, B receives a restricted stock grant subject

to B’s continued employment for the balance of

the contract. The restricted stock grant is not a

material modification of the binding written

contract because any additional compensation

paid to B under the grant is not paid on the basis

of substantially the same elements and conditions

as B’s salary because it is based both on the

stock price and B’s continued service. However,

compensation attributable to the restricted stock

grant is subject to the deduction limitation of

section 162(m).

(2) Special transition rule for outside directors. A director who is a

disinterested director is treated as satisfying the requirements of an outside

director under paragraph (e)(3) of this

section until the first meeting of

shareholders at which directors are to

be elected that occurs on or after

January 1, 1996. For purposes of this

paragraph (h)(2) and paragraph (h)(3)

of this section, a director is a disinterested director if the director is

disinterested within the meaning of

Rule 16b–3(c)(2)(i), 17 CFR 240.16b–

3(c)(2)(i), under the Exchange Act

(including the provisions of Rule 16b–

3(d)(3), as in effect on April 30, 1991).

(3) Special transition rule for previously-approved plans—(i) In general.

Any compensation paid under a plan or

agreement approved by shareholders

before December 20, 1993, is treated as

satisfying the requirements of para-

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graphs (e)(3) and (e)(4) of this section,

provided that the directors administering the plan or agreement are disinterested directors and the plan was

approved by shareholders in a manner

consistent with Rule 16b–3(b), 17 CFR

240.16b–3(b), under the Exchange Act

or Rule 16b–3(a), 17 CFR 240.16b–

3(a) (as contained in 17 CFR part 240

revised April 1, 1990). In addition, for

purposes of satisfying the requirements

of paragraph (e)(2)(vi) of this section, a

plan or agreement is treated as stating a

maximum number of shares with respect to which an option or right may

be granted to any employee if the plan

or agreement that was approved by the

shareholders provided for an aggregate

limit, consistent with Rule 16b–3(b), 17

CFR 250.16b–3(b), on the shares of

employer stock with respect to which

awards may be made under the plan or

agreement.

(ii) Reliance period. The transition

rule provided in this paragraph (h)(3)

shall continue and may be relied upon

until the earliest of—

(A) The expiration or material

modification of the plan or agreement;

(B) The issuance of all employer

stock and other compensation that has

been allocated under the plan; or

at which directors are to be elected that

occurs after December 31, 1996.

(iii) Stock-based compensation. This

paragraph (h)(3) will apply to any

compensation received pursuant to the

exercise of a stock option or stock

appreciation right, or the substantial

vesting of restricted property, granted

under a plan or agreement described in

paragraph (h)(3)(i) of this section if the

grant occurs on or before the earliest of

the events specified in paragraph

(h)(3)(ii) of this section.

(iv) Example. The following example illustrates the application of this

paragraph (h)(3):

Example. Corporation Z adopted a stock

option plan in 1991. Pursuant to Rule 16b-3

under the Exchange Act, the stock option plan

has been administered by disinterested directors

and was approved by Corporation Z shareholders. Under the terms of the plan, shareholder

approval is not required again until 2001. In

addition, the terms of the stock option plan

include an aggregate limit on the number of

shares available under the plan. Option grants

under the Corporation Z plan are made with an

exercise price equal to or greater than the fair

market value of Corporation Z stock. Compensation attributable to the exercise of options that

are granted under the plan before the earliest of

the dates specified in paragraph (h)(3)(ii) of this

section will be treated as satisfying the requirements of paragraph (e) of this section for

qualified performance-based compensation, regardless of when the options are exercised.

(i) (Reserved)

(j) Effective date—(1) In general.

Section 162(m) and this section apply

to compensation that is otherwise deductible by the corporation in a taxable

year beginning on or after January 1,

1994.

(2) Delayed effective date for certain

provisions—(i) Date on which remuneration is considered paid. Notwithstanding paragraph (j)(1) of this

section, the rules in the second sentence of each of paragraphs (e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C) of

this section for determining the date or

dates on which remuneration is considered paid to a director are effective for

taxable years beginning on or after

January 1, 1995. Prior to those taxable

years, taxpayers must follow the rules

in paragraphs (e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C) of this section

or another reasonable, good faith interpretation of section 162(m) with respect to the date or dates on which

remuneration is considered paid to a

director.

(ii) Separate treatment of publicly

held subsidiaries. Notwithstanding

paragraph (j)(1) of this section, the rule

in paragraph (c)(1)(ii) of this section

that treats publicly held subsidiaries as

separately subject to section 162(m) is

effective as of the first regularly

scheduled meeting of the shareholders

of the publicly held subsidiary that

occurs more than 12 months after

December 2, 1994. The rule for stockbased compensation set forth in paragraph (f)(3) of this section will apply

for this purpose, except that the grant

must occur before the shareholder

meeting specified in this paragraph

(j)(2)(ii). Taxpayers may choose to rely

on the rule referred to in the first

sentence of this paragraph (j)(2)(ii) for

the period prior to the effective date of

the rule.

(iii) Subsidiaries that become separate publicly held corporations. Notwithstanding paragraph (j)(1) of this

section, if a subsidiary of a publicly

held corporation becomes a separate

publicly held corporation as described

in paragraph (f)(4)(i) of this section,

then, for the duration of the reliance

period described in paragraph (f)(2) of

this section, the rules of paragraph

(f)(1) of this section are treated as

applying (and the rules of paragraph

(f)(4) of this section do not apply) to

remuneration paid to covered

employees of that new publicly held

corporation pursuant to a plan or

agreement that existed prior to December 2, 1994, provided that the treatment

of that remuneration as performancebased is in accordance with a reasonable, good faith interpretation of section 162(m). However, if remuneration

is paid to covered employees of that

new publicly held corporation pursuant

to a plan or agreement that existed

prior to December 2, 1994, but that

remuneration is not performance-based

under a reasonable, good faith interpretation of section 162(m), the rules

of paragraph (f)(1) of this section will

be treated as applying only until the

first regularly scheduled meeting of

shareholders that occurs more than 12

months after December 2, 1994. The

rules of paragraph (f)(4) of this section

will apply as of that first regularly

scheduled meeting. The rule for stockbased compensation set forth in paragraph (f)(3) of this section will apply

for purposes of this paragraph

(j)(2)(iii), except that the grant must

occur before the shareholder meeting

specified in the preceding sentence if

the remuneration is not performancebased under a reasonable, good faith

interpretation of section 162(m). Taxpayers may choose to rely on the rules

of paragraph (f)(4) of this section for

the period prior to the applicable effective date referred to in the first or

second sentence of this paragraph

(j)(2)(iii).

(iv) Bonus Pools. Notwithstanding

paragraph (j)(1) of this section, the

rules in paragraph (e)(2)(iii)(A) that

limit the sum of individual percentages

of a bonus pool to 100 percent will not

apply to remuneration paid before

January 1, 2001, based on performance

in any performance period that began

prior to December 20, 1995.

(v) Compensation based on a percentage of salary or base pay. Notwithstanding paragraph (j)(1) of this

section, the requirement in paragraph

(e)(4)(i) of this section that, in the case

of certain formulas based on a percentage of salary or base pay, a corporation

disclose to shareholders the maximum

dollar amount of compensation that

could be paid to the employee, will

apply only to plans approved by

shareholders after April 30, 1995.

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Par. 3. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Election in respect of losses attributable to a disaster. This ruling lists the

areas declared by the President to

qualify as major disaster areas under

the Disaster Relief and Emergency

Assistance Act since the publication of

Rev. Rul. 95–17.

§602.101 [Amended]

Rev. Rul. 96–13

Par.4. In §602.101, paragraph (c) is

amended by adding the entry ‘‘1.162–

27 . . . . 1545–1466’’ in numerical order

to the table.

Under § 165(i) of the Internal Revenue Code, if a taxpayer suffers a loss

attributable to a disaster occurring in an

area subsequently determined by the

President of the United States to

warrant assistance by the Federal Government under the Disaster Relief and

Emergency Assistance Act, 42 U.S.C.

§§ 5121–5204c (1988 & Supp. V 1993)

(the Act), the taxpayer may elect to

claim a deduction for that loss on the

taxpayer’s federal income tax return for

the taxable year immediately preceding

the taxable year in which the disaster

occurred.

Section 1.165–11(e) of the Income

Tax Regulations provides that the

election to deduct a disaster loss for the

preceding year must be made by filing

a return, an amended return, or a claim

for refund on or before the later of (1)

the due date of the taxpayer’s income

tax return (determined without regard

to any extension of time to file the

PART 602—OMB CONTROL

NUMBERS UNDER THE

PAPERWORK REDUCTION ACT

Margaret Milner Richardson,

Commissioner of

Internal Revenue.

Approved December 12, 1995.

Leslie Samuels,

Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

December 19, 1995, 8:45 a.m., and published

in the issue of the Federal Register for

December 20, 1995, 60 F.R. 65534)

Section 165.—Losses

26 CFR 1.165–11: Election in respect of

losses attributable to a disaster.

Disaster Areas in 1995

Alabama

Counties of Cullman, DeKalb, Marion, Marshall,

and Winston

Counties of Autauga, Baldwin, Barbour, Bullock,

Bulter, Calhoun, Chambers, Cherokee, Chilton,

Clarke, Clay, Cleburne, Coffee, Conecuh, Coosa,

Covington, Crenshaw, Cullman, Dale, DeKalb,

Elmore, Escambia, Etowah, Geneva, Henry,

Houston, Jefferson, Lee, Lowndes, Macon, Mobile,

Montgomery, Pike, Randolph, Russell, St. Clair,

Talladega, and Tallapoosa

Alaska

Chugach and Copper River Education Attendance

Areas (these areas include the City of Cordova,

the City of Valdez, and the Richardson, Cooper

River, and Edgerton Highway Areas); Municipality

of Anchorage; Kenai Peninsula Borough, Kodiak

Island Borough, and Matanuska-Susitna Borough

return) for the taxable year in which

the disaster actually occurred, or (2)

the due date of the taxpayer’s income

tax return (determined with regard to

any extension of time to file the return)

for the taxable year immediately preceding the taxable year in which the

disaster actually occurred.

The provisions of § 165(i) apply

only to losses that are otherwise

deductible under § 165(a). An individual taxpayer may deduct losses if they

are incurred in a trade or business, if

they are incurred in a transaction

entered into for profit, or if they are

casualty losses under § 165(c)(3).

The President has determined that

during 1995 the areas listed below have

been adversely affected by disasters of

sufficient severity and magnitude to

warrant assistance by the Federal Government under the Act.

DRAFTING INFORMATION

The principal author of this revenue

ruling is David B. Auclair of the Office

of Assistant Chief Counsel (Income

Tax and Accounting). For further information regarding this revenue ruling,

contact Mr. Auclair on (202) 622-4910

(not a toll-free call).

Type of Disaster

Date of Disaster

Severe storms, tornadoes,

and flooding

Hurricane Opal

February 15-20, 1995

Severe storms and flooding

September 18-October 10, 1995

October 4-8, 1995

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Disaster Areas in 1995

California

Counties of Alameda, Amador, Butte, Colusa,

Contra Costa, Del Norte, El Dorado, Glenn, Humboldt, Kern, Kings, Lake, Lassen, Los Angeles,

Madera, Marin, Mendocino, Modoc, Monterey,

Napa, Nevada, Orange, Placer, Plumas, Riverside,

Sacramento, San Bernardino, San Diego, San

Mateo, San Luis Obispo, Santa Barbara, Santa

Clara, Santa Cruz, Shasta, Solano, Sonoma, Sutter,

Tehama, Trinity, Ventura, Yolo, and Yuba

Counties of Alameda, Alpine, Amador, Butte,

Calaveras, Colusa, Contra Costa, El Dorado,

Fresno, Glenn, Humboldt, Imperial, Inyo, Kern,

Kings, Lake, Lassen, Los Angeles, Madera, Marin,

Mariposa, Mendocino, Merced, Modoc, Mono,

Monterey, Napa, Nevada, Orange, Placer, Plumas,

Riverside, Sacramento, San Benito, San Bernardino, San Diego, San Francisco, San Joaquin, San

Luis Obispo, San Mateo, Santa Barbara, Santa

Clara, Santa Cruz, Shasta, Sierra, Siskiyou,

Sonoma, Solano, Stanislaus, Sutter, Tehama, Trinity, Tulare, Tuolumne, Ventura, Yolo, and Yuba

Florida

Counties of Bay, Brevard, Escambia, Okaloosa,

Santa Rosa, and Walton

Counties of Bay, Calhoun, Escambia, Franklin,

Gadsden, Gulf, Holmes, Jackson, Leon, Liberty,

Okaloosa, Santa Rosa, Taylor, Wakulla, Walton,

and Washington

Counties of Collier and Lee

Counties of Martin, Palm Beach, and St. Lucie

Georgia

Counties of Banks, Barrow, Bartow, Carroll,

Catoosa, Chattooga, Cherokee, Clay, Clayton,

Cobb, Coweta, Dade, Dawson, Dekalb, Douglas,

Fannin, Fayette, Floyd, Forsyth, Fulton, Gilmer,

Gordon, Gwinnett, Habersham, Hall, Haralson,

Harris, Heard, Lumpkin, Meriwether, Murray,

Muscogee, Paulding, Pickens, Pike, Polk, Quitman,

Rabun, Randolph, Rockdale, Spalding, Stewart,

Talbot, Towns, Troup, Union, Upson, Walker,

White, and Whitfield

City of Albany located in Dougherty County

Illinois

Counties of Alexander, Brown, Calhoun, Cass,

Fulton, Greene, Jackson, Jersey, Madison, Mason,

Monroe, Morgan, Pike, Pulaski, Randolph,

Schuyler, Scott, St. Clair, and Union

Kentucky

Counties of Adair, Bath, Boyd, Breathitt,

Breckinridge, Carter, Casey, Christian, Clark,

Cumberland, Elliot, Floyd, Fulton, Green, Hardin,

Jackson, Jessamine, Johnson, Lawrence, Laurel,

Magoffin, Meade, Mercer, Montgomery, Owsley,

Perry, Pike, Pulaski, Rockcastle, Rowan, Russell,

and Taylor

Type of Disaster

Date of Disaster

Severe winter storms

January 3-February 10, 1995

Severe winter storms

February 13-April 19, 1995

Hurricane Erin

August 2-3, 1995

Hurricane Opal

October 4-11, 1995

Hurricane Opal

Severe storms and flooding

October 4-31, 1995

October 13-November 20, 1995

Severe storms and tornadoes

November 7-8, 1995

Severe storms and flooding

May 15-June 15, 1995

Tornadoes, severe wind

and hail storms, torrential rain, and flooding

May 13-19, 1995

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Disaster Areas in 1995

Type of Disaster

Date of Disaster

Louisiana

Parishes of Ascension, Assumption, Jefferson,

LaFourche, Orleans, St. Bernard, St. Charles, St.

James, St. John, St. Tammany, Tangipahoa, and

Terrebonne

Severe storms, tornadoes,

and flooding

May 8-16, 1995

Severe storms, straight line

winds, and tornadoes

July 9-14, 1995

Severe ice storm

October 23-24, 1995

Severe storms, tornadoes,

and flooding

May 8-17, 1995

Severe storms, hail, tornadoes, and flooding

May 13-June 23, 1995

Excessive rain, high winds,

and flooding

October 20-November 15,

1995

Severe storm, high winds,

and flooding

October 4-6, 1995

Severe storms, flooding,

and ground saturation due

to high water tables

March 1-July 5, 1995

Severe storms and flooding

August 7-18, 1995

Explosion at the Alfred P.

Murrah Federal Building in

Oklahoma City

Severe storms, flooding,

and tornadoes

April 19, 1995

Minnesota

Counties of Aitkin, Becker, Beltrami, Cass, Clay,

Clearwater, Crow Wing, Hubbard, Itasca, Kittson,

Mahnomen, Otter Tail, St. Louis, Wadena, and Wilkin,

and White Earth Indian Reservation

Counties of Big Stone, Stevens, Swift, and Traverse

Mississippi

Counties of Hancock, Harrison, Jackson, and Pearl

River

Missouri

City of St. Louis; Counties of Adair, Andrew, Atchinson, Barry, Barton, Bates, Benton, Boone, Callaway,

Camden, Cape Girardeau, Carroll, Cass, Chariton,

Clark, Cole, Cooper, Dallas, Daviess, Dekalb, Franklin,

Gasconade, Gentry, Henry, Howard, Jackson, Jasper,

Jefferson, Johnson, Lafayette, Lewis, Lincoln, Linn,

Macon, Maries, McDonald, Mercer, Miller, Mississippi,

Moniteau, Montgomery, Morgan, New Madrid, Newton,

Nodaway, Osage, Pemiscot, Perry, Ray, Saint Francois,

Saline, Scotland, Scott, St. Charles, St. Clair, Ste.

Genevieve, St. Louis, Stone, Sullivan, Vernon, and

Warren

New Hampshire

Counties of Carroll, Cheshire, Coos, Grafton,

Merrimack, and Sullivan

North Carolina

Counties of Ashe, Avery, Cherokee, Clay, Graham,

Haywood, Jackson, Macon, Madison, Mitchell, Swain,

Transylvania, Watauga, Wilkes, and Yancey; the

Eastern Band of the Cherokee Indian Reservation

North Dakota

Counties of Barnes, Benson, Bottineau, Burleigh,

Cavalier, Dickey, Eddy, Emmons, Foster, Griggs, Kidder, La Moure, Logan, McHenry, McIntosh, McLean,

Nelson, Pembina, Pierce, Ramsey, Ransom, Renville,

Rolette, Sargent, Sheridan, Sioux, Steele, Stutsman,

Towner, Traill, Walsh, and Wells

Ohio

Counties of Champaign, Erie, Licking, Logan, Lorain,

Marion, Mercer, Miami, Scioto, Shelby, and Washington

Oklahoma

City of Oklahoma City; County of Oklahoma

Counties of Alfalfa, Atoka, Beckham, Caddo, Canadian, Carter, Cotton, Creek, Custer, Ellis, Grady,

Grant, Harmon, Jackson, Kingfisher, Kiowa, Lincoln,

Logan, Major, Murray, Nowata, Osage, Ottawa, Pottawatomie, Roger Mills, Seminole, Tillman, Washita,

and Woodward

May 26-June 11, 1995

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Disaster Areas in 1995

Counties of Alfalfa, Blaine, Caddo, Canadian, Cotton,

Custer, Grant, Greer, Harmon, Jackson, Kay, Kiowa,

Major, Oklahoma, Tillman, Washita, and Woods

Oregon

County of Wasco

Puerto Rico

Municipalities of Aquas Buenas, Barranquitas,

Canovanas, Carolina, Ceiba, Ciales, Comerio, Culebra,

Fajardo, Juncos, Loiza, Naguabo, San Lorenzo, and

Vieques

South Dakota

Counties of Aurora, Brule, Buffalo, Campbell, Corson,

Dewey, Edmunds, Faulk, Haakon, Hand, Hughes,

Hyde, Jerauld, Jones, Lyman, McPherson, Potter,

Stanley, Sully, Walworth, and Ziebach

Counties of Aurora, Beadle, Bon Homme, Brookings,

Brown, Brule, Buffalo, Butte, Campbell, Charles Mix,

Clark, Clay, Codington, Custer, Davison, Day, Deuel,

Douglas, Edmunds, Faulk, Grant, Gregory, Haakon,

Hamlin, Hand, Hanson, Hughes, Hutchinson, Hyde,

Jerauld, Jones, Kingsbury, Lake, Lawrence, Lincoln,

Lyman, Marshall, McCook, McPherson, Meade, Miner,

Moody, Pennington, Potter, Roberts, Sanborn, Spink,

Stanley, Sully, Tripp, Turner, Walworth, and Yankton

Counties of Aurora, Beadle, Bon Homme, Brookings,

Brule, Buffalo, Charles Mix, Clark, Codington,

Davison, Deuel, Douglas, Grant, Gregory, Hamlin,

Hanson, Hutchinson, Jerauld, Kingsbury, Lake,

McCook, Miner, Roberts, Sanborn, Spink, and Tripp

Tennesee

Counties of Cumberland, Houston, Lake, Lauderdale,

and Lawrence

Texas

County of Tom Green

U.S. Virgin Islands

Islands of St. Croix, St. John, and St. Thomas

Vermont

Counties of Caledonia, Chittenden, Essex, Lamoille,

Orleans, and Washington

Virginia

Cities of Bedford, Buena Vista, Lexington, Lynchburg,

Roanoke, and Staunton; Counties of Albemarle,

Amherst, Augusta, Bath, Bedford, Campbell, Culpeper,

Franklin, Giles, Greene, Halifax, Madison, Orange, Pittsylvania, Rappahannock, Roanoke, Rockbridge, and

Warren

Washington

Counties of Chelan, Clallam, Clark, Cowlitz, Grays

Harbor, Island, Jefferson, King, Kittitas, Lewis, Mason,

Pacific, Pierce, Skagit, Snohomish, Thurston,

Wahkiakum, Whatcom, and Yakima

Type of Disaster

Date of Disaster

Tornadoes, severe storms,

and flooding

July 21-August 6, 1995

Flash flooding

July 8-9, 1995

Hurricane Marilyn

September 15-17, 1995

Severe winter storms

January 13-February 10,

1995

Severe storms, flooding,

and ground saturation due

to high water tables

March 1-June 20, 1995

Severe winter storm

October 22-24, 1995

Severe stroms and tornadoes

May 14-19, 1995

Severe thunderstorms,

flooding, hail, and tornadoes

May 28-31, 1995

Hurricane Marilyn

September 15-17, 1995

Excessive rain and flooding

August 4-6, 1995

Severe storms and flooding

June 22-July 7, 1995

Severe storms, high wind,

and flooding

November 7-December 18,

1995

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Disaster Areas in 1995

West Virginia

Counties of Mercer, Mineral, and Nicholas

Type of Disaster

Date of Disaster

Severe storms, heavy

rain, and flash flooding

June 23-28, 1995

Section 358.—Basis to Distributees

SUPPLEMENTARY INFORMATION:

26 CFR 1.358–6: Stock basis in certain

triangular reorganizations.

Background

T.D. 8648

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Controlling Corporation’s Basis

Adjustment in its Controlled

Corporation’s Stock Following a

Triangular Reorganization

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations under sections 358,

1032, and 1502 of the Internal Revenue

Code of 1986. The final regulations

provide rules for adjusting the basis of

a controlling corporation in the stock of

a controlled corporation as the result of

certain triangular reorganizations involving the stock of the controlling

corporation. They also generally provide that the use of the controlling

corporation’s stock provided by the

controlling corporation pursuant to the

plan of reorganization is treated as a

disposition of those shares by the

controlling corporation.

DATES: These regulations are effective

December 21, 1995.

For dates of applicability, see the

‘‘Effective Dates’’ section under the

‘‘SUPPLEMENTARY INFORMATION’’ portion of the preamble and the

effective date provisions of the new or

revised regulations.

FOR FURTHER INFORMATION

CONTACT: Curt Cutting, (202)

622-7550 (not a toll-free number).

This document contains final regulations under sections 358, 1032, and

1502. The proposed regulations were

published in the Federal Register on

December 23, 1994 (59 F.R. 66280

[CO–993–71], 1995–1 C.B. 832. The

IRS received many comments on the

proposed regulations and held a public

hearing on March 31, 1995.

After consideration of the comments

and the statements made at the hearing,

the proposed regulations are adopted as

revised by this Treasury decision.

Overview

The final regulations adopt the overthe-top model contained in the proposed regulations. Subject to certain

modifications, the model generally adjusts a controlling corporation’s (P’s)

basis in the stock of its controlled

corporation (S or T) as a result of

certain triangular reorganizations as if

P had acquired the T assets (and any

liabilities assumed or to which the T

assets were subject) directly from T in

a transaction in which P’s basis in the

T assets was determined under section

362(b), and P then had transferred the

T assets (and liabilities) to S in a

transaction in which P’s basis in the S

or T stock was adjusted under section

358. The preamble to the proposed

regulations contains a discussion of the

justification for the model. See 59 FR

66280–81.

The final regulations also provide a

special rule that treats S’s use of P’s

stock provided by P pursuant to the

plan of reorganization as a disposition

of those shares by P.

The final regulations apply only for

the purpose of determining P’s basis in

its S or T stock following a transaction

that otherwise qualifies as a reorganization within the meaning of section 368.

They do not address issues concerning

the qualification of a transaction as a

reorganization.

With the publication of these final

regulations, the IRS announces the

closing of its study project referred to

in §5.14 of Rev. Proc. 95–3, 1995–1

C.B. 385, 395.

The significant comments on the

proposed regulations and revisions

made are discussed below.

Summary of comments and

explanation of revisions

P’s basis in T stock owned before

a reverse triangular merger

The proposed regulations adjusted

basis as a result of a reverse triangular

merger to reflect the amount of T stock

received in the transaction. Comments

on the proposed regulations questioned

how an adjustment based on the

amount of T stock received in the

transaction would apply in the case in

which P owns T stock before the

transaction.

In response to these comments, the

final regulations allow P to treat its T

stock as acquired in the transaction or

not, without regard to the form of the

transaction. Thus, P may retain its basis

in the T stock owned before the transaction, or may determine its basis in

that stock as an allocable portion of T’s

net asset basis. The regulations require

no explicit election. Instead, it is

assumed P will pick the higher basis.

This rule applies only for determining

basis, and not for qualifying the transaction as a reverse triangular merger.

See Rev. Rul. 74–564, 1974–2 C.B.

124.

The Treasury and the IRS continue

to study issues relating to restructurings

involving related parties and crossownership, and welcome comments and

suggestions on these issues.

Net negative adjustment

Under the proposed regulations, P’s

basis adjustment was reduced by the

fair market value of consideration not

provided by P, and by the amount of

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liabilities assumed by S or to which T

assets are subject. These reductions did

not result in a net negative basis

adjustment to P’s basis in its S stock

before the transaction. This limitation

did not apply, however, where P and S,

or P and T, as applicable, were

members of a consolidated group following the triangular reorganization. In

the consolidated context, the negative

adjustments could result in a net

negative adjustment to P’s basis in its

S stock before the transaction, even if

the adjustment resulted in an excess

loss account under §1.1502–19.

Some comments on the proposed

regulations argued against reducing P’s

basis in its S stock before the transaction by a net negative adjustment in the

consolidated context. Other comments,

however, agreed that it is appropriate

not to limit the net negative adjustment

in this context.

The Treasury and the IRS continue

to believe that the proposed regulations

reach the correct result. Therefore, the

final regulations adopt the rules as

proposed.

Overlap of reverse triangular

merger and other transactions

The proposed regulations provided

that if a transaction qualified as both a

reverse triangular merger and a stock

acquisition under section 368(a)(1)(B),

P adjusted its basis in its T stock based

either on T’s net asset basis or on the

aggregate basis of the T stock surrendered in the transaction (as if the

transaction were a reorganization under

section 368(a)(1)(B)).

One comment noted that a reverse

triangular merger might overlap with a

section 351 transfer and therefore requested that this rule also apply to such

a case. The final regulations adopt this

suggestion.

Manner of making elections

The proposed and final regulations

provide P with elections for its basis

adjustments when P owns stock of T

and when a reverse triangular merger

also qualifies as a section 351 transaction or B reorganization. In these

situations, P does not have to declare

how it will compute its basis. Rather, P

must simply retain appropriate records.

See §1.368–3.

Application of section 1032

The proposed regulations under section 1032 generally provided that P

stock provided by P to S, or directly to

T or T’s shareholders on behalf of S,

pursuant to the plan of reorganization

would be treated as a disposition by P

of shares of its own stock for T assets

or stock, as applicable. Thus, no gain

or loss was recognized on the use of

such P stock in the transaction. S,

however, recognized gain or loss on its

use of P stock if S did not receive the

stock from P as part of the plan of

reorganization. This rule did not apply

in the case of a reverse triangular

merger; section 361 provides nonrecognition treatment for S’s use of P stock

in such a case. To clarify this treatment, a cross-reference has been added

to the final regulations.

Comments to the proposed regulations requested that they be expanded

to cover P debt, warrants and options

provided by P to S, or directly to T or

T’s shareholders on behalf of S,

pursuant to the plan of reorganization.

Comments also requested that the rule

be extended to taxable transactions.

The issues raised in these comments

are beyond the scope of this project.

However, the Treasury and the IRS are

studying issues relating to the scope of

section 1032 and welcome comments

and suggestions.

Special analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

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) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not

apply to these regulations, and, therefore, a Regulatory Flexibility Analysis

is not required. Pursuant to section

7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking

preceding these regulations was submitted to the Small Business Administration for comment on its impact on

small business.

Effective dates

1994, the day that the proposed regulations were published in the Federal

As stated in the preamble to the

proposed regulations, any adjustment to

P’s basis in its S or T stock (as

applicable) following a triangular reorganization occurring before December

23, 1994, must be consistent with the

adjustment that would be made if P had

made the acquisition directly and P then

transferred the assets to a controlled

subsidiary. However, with respect to

reverse triangular mergers occurring

before December 23, 1994, P may adjust its basis in its T stock as if P

acquired the stock of the former T

shareholders in a transaction in which

its basis was determined under section

362(b).

Section 1.1032–2 applies with respect

to certain triangular reorganizations occurring on or after December 23, 1994.

With respect to triangular reorganizations occurring before December 23,

1994, see, e.g., §1.1032–1 and Rev. Rul.

57–278, 1957–1 C.B. 124.

Section 1.1502–30 applies with respect to triangular reorganizations occurring on or after December 21, 1995,

in which P and S, or P and T, as

applicable, are members of a consolidated group following the triangular

reorganization. For similar triangular

reorganizations occurring before December 21, 1995, any adjustments to

P’s basis in its S or T stock (as

applicable) must be consistent with the

rules applicable for nonconsolidated

taxpayers, except to the extent that

§1.1502–31 applies to a transaction that

is a group structure change.

Drafting information

The principal authors of these regulations are Rose Williams and Curt

Cutting, Office of Assistant Chief

Counsel (Corporate). However, other

personnel from the IRS and the Treasury Department participated in their

development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

amended as follows:

PART 1—INCOME TAXES

Generally, §1.358–6 applies with

respect to all triangular reorganizations

occurring on or after December 23,

Paragraph 1. The authority citation

for part 1 continues to read in part:

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

Section 1.1502–30 also issued under

26 U.S.C. 1502 * * *

Par. 2. Section 1.358–2(d) is

removed.

Par. 3. Section 1.358–6 is added to

read as follows:

§1.358–6 Stock basis in certain

triangular reorganizations.

(a) Scope. This section provides

rules for computing the basis of a

controlling corporation in the stock of a

controlled corporation as the result of

certain reorganizations involving the

stock of the controlling corporation as

described in paragraph (b) of this

section. The rules of this section are in

addition to rules under other provisions

of the Internal Revenue Code and

principles of law. See, e.g., section

1001 for the recognition of gain or loss

by the controlled corporation on the

exchange of property for the assets or

stock of a target corporation in a

reorganization described in section 368.

(b) Triangular reorganizations—(1)

Nomenclature. For purposes of this

section—

(i) P is a corporation—

(A) That is a party to a

reorganization,

(B) That is in control (within the

meaning of section 368(c)) of another

party to the reorganization, and

(ii) S is a corporation—

(A) That is a party to the reorganization, and

(B) That is controlled by P.

(iii) T is a corporation that is another party to the reorganization.

(2) Definitions of triangular reorganizations. This section applies to the

following reorganizations (which are

referred to collectively as triangular

reorganizations):

(i) Forward triangular merger. A

forward triangular merger is a statutory

merger of T and S, with S surviving,

that qualifies as a reorganization under

section 368(a)(1)(A) or (G) by reason

of the application of section 368(a)(2)(D).

(ii) Triangular C reorganization. A

triangular C reorganization is an acquisition by S of substantially all of T’s

assets in exchange for P stock in a

transaction that qualifies as a reorganization under section 368(a)(1)(C).

(iii) Reverse triangular merger. A

reverse triangular merger is a statutory

merger of S and T, with T surviving,

that qualifies as a reorganization under

section 368(a)(1)(A) by reason of the

application of section 368(a)(2)(E).

(iv) Triangular B reorganization. A

triangular B reorganization is an acquisition by S of T stock in exchange

for P stock in a transaction that

qualifies as a reorganization under

section 368(a)(1)(B).

special rule provided in paragraph (d)

of this section, P’s basis in the stock of

S or T, as applicable, as a result of a

triangular reorganization, is adjusted

under the following rules—

(1) Forward triangular merger or

triangular C reorganization—(i) In

general. In a forward triangular merger

or a triangular C reorganization, P’s

basis in its S stock is adjusted as if—

(A) P acquired the T assets acquired

by S in the reorganization (and P

assumed any liabilities which S assumed or to which the T assets

acquired by S were subject) directly

from T in a transaction in which P’s

basis in the T assets was determined

under section 362(b); and

(B) P transferred the T assets (and

liabilities which S assumed or to which

the T assets acquired by S were

subject) to S in a transaction in which

P’s basis in S stock was determined

under section 358.

(ii) Limitation. If, in applying section 358, the amount of T liabilities

assumed by S or to which the T assets

acquired by S are subject equals or

exceeds T’s aggregate adjusted basis in

its assets, the amount of the adjustment

under paragraph (c)(1)(i) of this section

is zero. P recognizes no gain under

section 357(c) as a result of a triangular reorganization.

(2) Reverse triangular merger—(i)

In general—(A) Treated as a forward

triangular merger. Except as otherwise

provided in this paragraph (c)(2), P’s

basis in its T stock acquired in a

reverse triangular merger equals its

basis in its S stock immediately before

the transaction adjusted as if T had

merged into S in a forward triangular

merger to which paragraph (c)(1) of

this section applies.

(B) Allocable share. If P acquires

less than all of the T stock in the

transaction, the basis adjustment described in paragraph (c)(2)(i)(A) of this

section is reduced in proportion to the

percentage of T stock not acquired in

the transaction. The percentage of T

stock not acquired in the transaction is

determined by taking into account the

fair market value of all classes of T

stock.

before the transaction. Solely for purposes of paragraphs (c)(2)(i)(A) and

(B) of this section, if P owns T stock

before the transaction, P may treat that

stock as acquired in the transaction or

not, without regard to the form of the

transaction.

(ii) Reverse triangular merger that

qualifies as a section 351 transfer or

section 368(a)(1)(B) reorganization.

Notwithstanding paragraph (c)(2)(i) of

this section, if a reorganization

qualifies as both a reverse triangular

merger and as a section 351 transfer or

as both a reverse triangular merger and

a reorganization under section 368(a)(1)(B), P can—

(A) Determine the basis in its T

stock as if paragraph (c)(2)(i) of this

section applies; or

(B) Determine the basis in the T

stock acquired as if P acquired such

stock from the former T shareholders in

a transaction in which P’s basis in the

T stock was determined under section

362(b).

(3) Triangular B reorganization. In

a triangular B reorganization, P’s basis

in its S stock is adjusted as if—

(i) P acquired the T stock acquired

by S in the reorganization directly from

the T shareholders in a transaction in

which P’s basis in the T stock was

determined under section 362(b); and

(ii) P transferred the T stock to S in

a transaction in which P’s basis in its S

stock was determined under section

358.

(4) Examples. The rules of this

paragraph (c) are illustrated by the

following examples. For purposes of

these examples, P, S, and T are

domestic corporations, P and S do not

file consolidated returns, P owns all of

the only class of S stock, the P stock

exchanged in the transaction satisfies

the requirements of the applicable

triangular reorganization provisions,

and the facts set forth the only

corporate activity.

Example 1. Forward triangular merger. (a)

Facts. T has assets with an aggregate basis of

$60 and fair market value of $100 and no

liabilities. Pursuant to a plan, P forms S with $5

cash (which S retains), and T merges into S. In

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the merger, the T shareholders receive P stock

worth $100 in exchange for their T stock. The

transaction is a reorganization to which sections

368(a)(1)(A) and (a)(2)(D) apply.

(b) Basis adjustment. Under §1.358–6(c)(1),

P’s $5 basis in its S stock is adjusted as if P

acquired the T assets acquired by S in the

reorganization directly from T in a transaction in

which P’s basis in the T assets was determined

under section 362(b). Under section 362(b), P

would have an aggregate basis of $60 in the T

assets. P is then treated as if it transferred the T

assets to S in a transaction in which P’s basis in

the S stock was determined under section 358.

Under section 358, P’s $5 basis in its S stock

would be increased by the $60 basis in the T

assets deemed transferred. Consequently, P has a

$65 basis in its S stock as a result of the

reorganization.

same as paragraph (a) of this Example 1, except

that S is an operating company with substantial

assets that has been in existence for several

years. P has a $110 basis in the S stock. Under

§1.358–6(c)(1), P’s $110 basis in its S stock is

increased by the $60 basis in the T assets

deemed transferred. Consequently, P has a $170

basis in its S stock as a result of the

reorganization.

(d) Mixed consideration. The facts are the

same as paragraph (a) of this Example 1, except

that the T shareholders receive P stock worth

$80 and $20 cash from P. Under section 358, P’s

$5 basis in its S stock is increased by the $60

basis in the T assets deemed transferred.

Consequently, P has a $65 basis in its S stock as

a result of the reorganization.

(e) Liabilities. The facts are the same as

paragraph (a) of this Example 1, except that T’s

assets are subject to $50 of liabilities, and the T

shareholders receive $50 of P stock in exchange

for their T stock. Under section 358, P’s basis in

its S stock is increased by the $60 basis in the T

assets deemed transferred and decreased by the

$50 of liabilities to which the T assets acquired

by S are subject. Consequently, P has a net basis

adjustment of $10, and a $15 basis in its S stock

as a result of the reorganization.

(f) Liabilities in excess of basis. The facts are

the same as in paragraph (a) of this Example 1,

except that T’s assets are subject to liabilities of

$90, and the T shareholders receive $10 of P

stock in exchange for their T stock in the

reorganization. Under §1.358–6(c)(1)(ii), the adjustment under §1.358–6(c) is zero if the amount

of the liabilities which S assumed or to which

the T assets acquired by S are subject exceeds

the aggregate adjusted basis in T’s assets.

Consequently, P has no adjustment in its S stock,

and P has a $5 basis in its S stock as a result of

the reorganization.

Example 2. Reverse triangular merger. (a)

Facts. T has assets with an aggregate basis of

$60 and a fair market value of $100 and no

liabilities. P has a $110 basis in its S stock.

Pursuant to a plan, S merges into T with T

surviving. In the merger, the T shareholders

receive $10 cash from P and P stock worth $90

in exchange for their T stock. The transaction is

a reorganization to which sections 368(a)(1)(A)

and (a)(2)(E) apply.

(b) Basis adjustment. Under §1.358–6(c)(2)(i)(A), P’s basis in the T stock acquired is P’s

$110 basis in its S stock before the transaction,

adjusted as if T had merged into S in a forward

triangular merger to which §1.358–6(c)(1) applies. In such a case, P’s $110 basis in its S

stock before the transaction would have been

increased by the $60 basis of the T assets

deemed transferred. Consequently, P has a $170

basis in its T stock immediately after the

transaction.

qualifies under section 368(a)(1)(B). The facts

relating to T are the same as in paragraph (a) of

this Example 2. P, however, forms S pursuant to

the plan of reorganization. The T shareholders

receive $100 worth of P stock (and no cash) in

exchange for their T stock. The T shareholders

have an aggregate basis in their T stock of $85

immediately before the reorganization. The reorganization qualifies as both a reverse triangular

merger and a reorganization under section

368(a)(1)(B). Under §1.358–6(c)(2)(ii), P may

determine its basis in its T stock either as if

§1.358–6(c)(2)(i) applied to the T stock acquired,

or as if P acquired the T stock from the former T

shareholders in a transaction in which P’s basis

in the T stock was determined under section

362(b). Accordingly, P may determine a basis in

its T stock of $60 (T’s net asset basis) or $85

(the T shareholders’ aggregate basis in the T

stock immediately before the reorganization).

(d) Allocable share in a reverse triangular

merger. The facts are the same as in paragraph

(a) of this Example 2, except that X, a 10%

shareholder of T, does not participate in the

transaction. The remaining T shareholders receive $10 cash from P and P stock worth $80 for

their T stock. P owns 90% of the T stock after

the transaction. Under 1.358–6(c)(2)(i)(A), P’s

basis in its T stock is P’s $110 basis in its S

stock before the reorganization, adjusted as if T

had merged into S in a forward triangular

merger. In such a case, P’s basis would have

been adjusted by the $60 basis in the T assets

deemed transferred. Under §1.358–6(c)(2)(i)(B),

however, the basis adjustment determined under

§1.358–6(c)(2)(i)(A) is reduced in proportion to

the percentage of T stock not acquired by P in

the transaction. The percentage of T stock not

acquired in the transaction is 10%. Therefore, P

reduces its $60 basis adjustment by 10%,

resulting in a net basis adjustment of $54.

Consequently, P has a $164 basis in its T stock

as a result of the transaction.

(e) P’s ownership of T stock. The facts are the

same as in paragraph (a) of this Example 2,

except that P owns 10% of the T stock before

the transaction. P’s basis in that T stock is $8.

All the T shareholders other than P surrender

their T stock for $10 cash from P and P stock

worth $80. P does not surrender the stock in the

transaction. Under §1.358–6(c)(2)(i)(C), P may

treat its T stock owned before the transaction as

acquired in the transaction or not. If P treats that

T stock as acquired in the transaction, P’s basis

in that T stock and the T stock actually acquired

in the transaction equals P’s $110 basis in its S

stock before the transaction, adjusted by the $60

basis of the T assets deemed transferred, for a

total basis of $170. If P treats its T stock as not

acquired, P retains its $8 pre-transaction basis in

that stock. P’s basis in its other T shares equals

P’s $110 basis in its S stock before the

transaction, adjusted by $54 (the $60 basis in the

T assets deemed transferred, reduced by 10%),

for a total basis of $164 in those shares. See

§1.358–6(c)(2)(i)(A) and (B). Consequently, if P

treats its T shares as not acquired, P’s total basis

in all of its T shares is $172.

Example 3. Triangular B reorganization. (a)

Facts. T has assets with a fair market value of

$100 and no liabilities. The T shareholders have

an aggregate basis in their T stock of $85

immediately before the reorganization. Pursuant

to a plan, P forms S with $5 cash and S acquires

all of the T stock in exchange for $100 of P

stock. The transaction is a reorganization to

which section 368(a)(1)(B) applies.

(b) Basis adjustment. Under §1.358–6(c)(3), P

adjusts its $5 basis in its S stock by treating P as

if it acquired the T stock acquired by S in the

reorganization directly from the T shareholders in

exchange for the P stock in a transaction in

which P’s basis in the T stock was determined

under section 362(b). Under section 362(b), P

would have an aggregate basis of $85 in the T

stock received by S in the reorganization. P is

then treated as if it transferred the T stock to S in

a transaction in which P’s basis in the S stock

was determined under section 358. Under section

358, P’s basis in its S stock would be increased

by the $85 basis in the T stock deemed transferred. Consequently, P has a $90 basis in its S

stock as a result of the reorganization.

(d) Special rule for consideration

not provided by P—(1) In general. The

amount of P’s adjustment to basis in its

S or T stock, as applicable, described in

paragraph (c) of this section is decreased by the fair market value of any

consideration (including P stock in

which gain or loss is recognized, see

§1.1032–2(c)) that is exchanged in the

reorganization and that is not provided

by P pursuant to the plan of reorganization. This paragraph (d) does not

apply to the amount of T liabilities

assumed by S or to which the T assets

acquired by S are subject under paragraph (c)(1) of this section (or deemed

assumed or taken subject to by S under

paragraph (c)(2)(i) of this section).

(2) Limitation. P makes no adjustment to basis under this section if the

decrease required under paragraph

(d)(1) of this section equals or exceeds

the amount of the adjustment described

in paragraph (c) of this section.

(3) Example. The rules of this paragraph (d) are illustrated by the following example. For purposes of this

example, P, S, and T are domestic

corporations, P and S do not file

consolidated returns, P owns all of the

only class of S stock, the P stock

exchanged in the transaction satisfies

the requirements of the applicable

triangular reorganization

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