Certain Asset Transfers to a Tax-Exempt Entity

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8802]

RIN 1545-AN21

Certain Asset Transfers to a Tax-Exempt Entity

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations that implement

provisions of the Tax Reform Act of 1986 and the Technical and

Miscellaneous Revenue Act of 1988. The final regulations generally

affect a taxable corporation that transfers all or substantially all of

its assets to a tax-exempt entity or converts from a taxable

corporation to a tax-exempt entity in a transaction other than a

liquidation, and generally require the taxable corporation to recognize

gain or loss as if it had sold the assets transferred at fair market

value.

DATES: Effective Date: These regulations are effective January 28,

1999.

Applicability Date: For dates of applicability of these

regulations, see Sec. 1.337(d)-4(e).

FOR FURTHER INFORMATION CONTACT: Stephen R. Cleary, (202) 622-7530 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information in these final regulations has been

reviewed and, pending receipt and evaluation of public comments,

approved by the Office of Management and Budget (OMB) under 44 U.S.C.

3507 and assigned control number 1545-1633.

The collection of information in this regulation is described in

Sec. 1.337(d)-4(b)(1)(i). The information is a written representation

made by a tax-exempt entity estimating the percentage it will use

assets formerly held by a taxable corporation in an activity the income

from which is subject to tax under section 511(a), as opposed to other

activities. The information may be used by the taxable corporation in

computing the amount of gain or loss that is recognized under the

regulations. The information may also be used by the IRS in determining

whether the proper amount of tax is due on the transaction. The

collection of information is not mandatory but will enable the taxable

corporation to support its reporting of the tax consequences of the

transaction. The likely respondents are tax-exempt entities subject to

the unrelated business income tax under section 511(a) (including most

organizations that are exempt from tax under section 501, state

colleges and universities, and certain charitable trusts).

Comments concerning the collection of information should be sent 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, with copies to the Internal Revenue

Service, Attention: IRS Reports Clearance Officer, OP:FS:FP,

Washington, DC 20224. Any such comments should be submitted not later

than March 1, 1999.

Comments are specifically requested concerning:

(a) Whether the collection of information is necessary for the

proper performance of the functions of the Internal Revenue Service,

including whether the information will have practical utility;

(b) The accuracy of the estimated burden associated with the

collection of information (see below);

(c) How the quality, utility, and clarity of the information

requested may be enhanced;

(d) How the burden of complying with the collection of information

may be minimized, including through the application of automated

collection techniques or other forms of information technology; and

(e) Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

Estimated total annual reporting burden: 125 hours. The annual

burden per respondent varies from 1 hour to 10 hours, depending on

individual circumstances, with an estimated average of 5 hours.

Estimated number of respondents: 25.

Estimated frequency of responses: Once.

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 assigned by OMB.

Books or records relating to a 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

return information are confidential, as required by 26 U.S.C. 6103.

Background

On January 15, 1997, proposed regulations Sec. 1.337(d)-4 were

published in the Federal Register (62 FR 2064, [REG-209121-89, 1997-1

C.B. 719]). The regulations were proposed to amend 26 CFR part 1 and

were intended to carry out the purposes of the repeal of the General

Utilities doctrine (``General Utilities repeal'') as enacted in the Tax

Reform Act of 1986 (the ``1986 Act'').

The 1986 Act amended sections 336 and 337, generally requiring

corporations to recognize gain or loss when appreciated or depreciated

property is distributed in complete liquidation or is sold in

connection with a complete liquidation. Section 337(d) directs the

Secretary to prescribe regulations as may be necessary to carry out the

purposes of General Utilities repeal, including rules to ``ensure that

these purposes shall not be circumvented * * * through the use of a * *

* tax-exempt entity.''

The legislative history concerning a 1988 amendment to section

337(d) explains:

The bill also clarifies in connection with the built-in gain

provisions of the Act that the Treasury Department shall prescribe

such regulations as may be necessary or appropriate to carry out

those provisions * * * . For example, this includes rules to

[[Page 71592]]

require the recognition of gain if appreciated property of a C

corporation is transferred to a * * * tax-exempt entity [footnote

32] in a carryover basis transaction that would otherwise eliminate

corporate level tax on the built-in appreciation.

[footnote 32] The Act generally requires recognition of gain if

a C corporation transfers appreciated assets to a tax exempt entity

in a section 332 liquidation. See Code section 337(b)(2).

S. Rep. No. 445, 100th Cong., 2d Sess. 66 (1988).

Explanation of Provision

A. The Proposed Rule

(1) A taxable corporation that transfers all or substantially all

of its assets to one or more tax-exempt entities is required to

recognize gain or loss as if the assets transferred were sold at their

fair market values (Sec. 1.337(d)-4(a)(1), Asset Sale Rule);

(2) A taxable corporation that changes its status to a tax-exempt

entity generally is treated as having transferred all of its assets to

a tax-exempt entity immediately before the change in status becomes

effective in a transaction governed by the Asset Sale Rule

(Sec. 1.337(d)-4(a)(2), Change in Status Rule);

(3) The Change in Status Rule does not apply (subject to

application of the anti-abuse rule) if the corporation formerly was

tax-exempt and the change in status is within three years of the later

of (a) the corporation first filing a return as a taxable corporation,

or (b) a final determination that the corporation had become a taxable

corporation (Sec. 1.337(d)-4(a)(3), 3-Year Rule);

(4) The Asset Sale Rule does not apply if the transferred assets

are used by the tax-exempt entity in an activity the income from which

is subject to the unrelated business tax under section 511(a);

notwithstanding any other provision of law, gain on such assets will

later be included in unrelated business taxable income when the tax-

exempt entity disposes of the assets or ceases to use the assets in an

activity the income from which is subject to tax under section 511(a)

(Sec. 1.337(d)-4(b)(1), UBTI Rule);

(5) The regulations apply to transfers of assets occurring after

January 28, 1999, unless the transfer is pursuant to a written

agreement which is (subject to customary conditions) binding on or

before that date (Sec. 1.337(d)-4(e), Effective Date Rule).

The IRS and Treasury Department received approximately 32 written

comments on the proposed regulations. In addition, the IRS held a

public hearing on the proposed regulations on May 6, 1997. After

consideration of all the written and oral comments, the IRS and

Treasury Department are adopting the proposed regulations as revised by

this Treasury Decision. The comments and changes to the regulations

made in response to the comments are summarized below.

B. Comments and Changes in Response to Comments

1. Asset Sale Rule

Some commentators questioned whether section 337(d) authorizes

taxation of asset transfers other than liquidations. Section 337(d)

authorizes regulations to prevent circumvention of General Utilities

repeal through the ``use of'' any provision of law or regulations

(specifically including the corporate reorganization rules in Part III

of Subchapter C). The statutory rules in sections 336 and 337(b)(2),

enacted as part of General Utilities repeal, provide for corporate-

level gain or loss recognition when a taxable corporation liquidates

into a controlling tax-exempt entity. The regulations published in this

Treasury Decision are intended to reach transactions that are

economically similar to those liquidations but take different forms,

such as a taxable corporation's transfer of substantially all of its

assets to a tax-exempt entity or a taxable corporation's change in

status resulting in its becoming a tax-exempt entity. The IRS and

Treasury Department believe that section 337(d) provides clear

authority for these regulations.

Some commentators questioned whether section 337(d) authorizes

regulations that would tax transfers of assets without consideration,

noting that making a gift generally does not cause the recognition of

gain to the donor. Other commentators claimed that the proposed

regulations, to the extent they apply to transfers of assets to

charitable organizations, conflict with the policy of the charitable

contribution deduction under section 170. The regulations do not affect

the tax treatment of a corporation's gift of a portion of its assets to

charity, nor do they affect the shareholders' tax treatment when

transferring all or any part of the corporation's assets to charity by

transferring all or any part of the corporation's stock to charity. The

regulations apply only to transfers of all or substantially all of the

assets of a taxable corporation to a tax-exempt entity or a taxable

corporation's conversion to a tax-exempt entity. If shareholders donate

all of a corporation's stock to a charity and the charity then

liquidates the corporation, section 337(b)(2) taxes the liquidating

corporation's gain. The final regulations, which remain unchanged from

the proposed regulations in this respect, tax a taxable corporation's

gain in other transactions that have the same economic effect.

One commentator proposed that the final regulations allow deferral

of gain recognition on any asset transferred to a tax-exempt entity

until the entity disposes of the asset. The commentator suggests a rule

similar to that of section 1374, which provides generally that a C

corporation that converts to being an S corporation is subject to tax

if it disposes of assets held at the time of conversion during the ten-

year period after the conversion. Under this rule, the tax-exempt

entity would not be taxed on the built-in gain in assets that it

retains. For the reasons stated above, the IRS and Treasury Department

have concluded that the regulations generally should follow the rule in

section 337(b)(2) rather than the rule contained in section 1374 to

best accomplish the goal set forth in the statute and legislative

history.

One commentator suggested that the Asset Sale Rule should not apply

to a taxable corporation transferring assets to a tax-exempt entity in

a like-kind exchange described in section 1031 or an involuntary

conversion described in section 1033. In transactions described in

these sections, the taxable corporation acquires replacement property

that has a basis determined by reference to the basis of the property

replaced. Because the built-in appreciation in the transferred asset is

preserved in the replacement asset and remains in the hands of a

taxable corporation, General Utilities repeal is not circumvented in

these transactions. Accordingly, the final regulations exclude

transactions from the Asset Sale Rule to the extent the transactions

qualify for nonrecognition of gain or loss under section 1031 or 1033.

Some commentators proposed removing section 528 homeowners

associations from the list of tax-exempt entities subject to the

regulations because dispositions of assets by a homeowners association

are subject to tax. Under section 528, homeowners associations are

subject to tax on all of their income except for exempt function

income, which is defined as fees, dues, or assessments from homeowners.

Gains from the sale of a homeowners association's property are taxable;

therefore, General Utilities repeal is not circumvented by transfers to

homeowners associations. In addition, the properties that become the

subject of section 528 homeowners associations generally are developed

as business

[[Page 71593]]

ventures, and the developer has substantial incentive to realize the

increase in value of its assets in connection with their transfer to

the association, thus providing additional protection with respect to

General Utilities repeal. Also, a homeowners association may alternate

between taxable and tax-exempt status because its exemption is based on

a year-by-year election under section 528(c)(1)(E). In a given year, a

homeowners association may prefer taxable status to tax-exempt status

under section 528 because a section 528 organization is taxed at a 30

percent flat rate on income other than membership fees, dues, or

assessments, while a taxable homeowners association is subject to tax

on all income but at the progressive rates of section 11 (15 to 35

percent). The tax on non-exempt income under section 528 may exceed the

tax the association would pay as a taxable corporation. Congress

anticipated that these entities may alternate between taxable and tax-

exempt status and that the assets of these entities will remain subject

to tax on transfer. Imposing a tax on appreciated property each time

such an entity converts its status could inhibit this flexibility. For

this reason, and because General Utilities repeal will not be

compromised, the IRS and Treasury Department believe that an

organization's election to be treated under section 528 for a tax year

should not trigger gain recognition. Accordingly, the final regulations

do not treat section 528 homeowners associations as tax-exempt entities

for purposes of section 337(d). For similar reasons, the final

regulations do not define political organizations described in section

527 as tax-exempt entities for purposes of section 337(d).

Some commentators suggested that social clubs that are tax-exempt

as organizations described in section 501(c)(7) should be removed from

the list of tax-exempt entities for purposes of section 337(d).

Commentators also suggested that tax-exempt social clubs be allowed to

defer gain on transactions subject to the regulations, because social

clubs may be subject to tax on gains from asset sales. Section

512(a)(3)(A) generally taxes the income of a section 501(c)(7) social

club except for the social club's ``exempt function income,'' as

defined in section 512(a)(3)(B). Section 512(a)(3)(A) also applies to

tax-exempt organizations described in section 501(c)(9), (17), or (20).

The final regulations, however, do not provide relief from the general

rules of the regulations for section 501(c)(7) organizations. Unlike

section 528 homeowners associations, section 501(c)(7) social clubs are

permitted to avoid gain recognition on certain asset sales. For

example, if the club replaces the property sold with other property

used directly in the performance of its tax-exempt function, no tax is

owed on any gain recognized. Because of these exceptions, the IRS and

Treasury Department believe that deferring tax on transfers of assets

to section 501(c)(7) organizations would not be consistent with General

Utilities repeal. Accordingly, the final regulations follow the

proposed regulations and apply to transfers of assets to section

501(c)(7) organizations.

2. Change in Status Rule

A significant number of commentators contended that the Change in

Status Rule could have a major adverse effect on mutual or cooperative

electric companies that are tax-exempt as organizations described in

section 501(c)(12). That section provides tax exemption for benevolent

life insurance associations of a purely local character, mutual ditch

or irrigation companies, mutual or cooperative telephone companies, or

like organizations (including mutual or cooperative electric

companies), but only if more than 85 percent of their income is

collected from members for the sole purpose of meeting losses and

expenses. The 85 percent test is applied annually, so that an electric

cooperative could be taxable one year and tax-exempt the next year. The

commentators requested that electric cooperatives be given relief from

the Change in Status Rule because business exigencies may cause these

cooperatives to fail the 85 percent test. They also noted that the

relief provided in the proposed regulations for organizations

temporarily losing their exempt status was insufficient because more

than 3 years may elapse before the organization once again meets the 85

percent test.

In addition to meeting the 85 percent test, section 501(c)(12)

organizations must operate according to cooperative principles to be

eligible for exemption. See Rev. Rul. 72-36, 1972-1 C.B. 151; Buckeye

Countrymark, Inc. v. Commissioner, 103 T.C. 547, 554-555 (1994), acq.

on other issues, 1997-1 C.B. 1; Puget Sound Plywood, Inc. v.

Commissioner, 44 T.C. 305, 308 (1965), acq. on other issues, 1966-2

C.B. 6. An organization may operate according to cooperative principles

yet fail the 85 percent test. Congress anticipated that section

501(c)(12) mutual or cooperative organizations could alternate between

taxable and tax-exempt status due to the operation of the 85 percent

income requirement. The IRS and Treasury Department do not believe it

is appropriate to treat these entities as having disposed of all their

assets when they regain tax-exempt status where the sole reason for

their becoming taxable was the failure to meet the 85 percent test.

Therefore, the final regulations provide that the Change in Status Rule

does not apply when an organization previously tax-exempt as an

organization described in section 501(c)(12) loses exemption solely

because it fails the 85 percent test and later regains tax-exempt

status, provided that in each intervening taxable year it meets all the

requirements for exemption under section 501(c)(12) except for the 85

percent test.

One commentator suggested that because social clubs alternate

between taxable and tax-exempt status they should be given relief

similar to that requested by section 501(c)(12) organizations. Social

clubs can lose their tax exemption if they generate excessive nonmember

income in a particular year. See S. Rep. No. 1318, 94th Cong., 2d Sess.

4 (1976), 1976-2 C.B. 599. After considering this comment and the

Service's experience with these organizations, we have concluded that

the 3-Year Rule will provide adequate relief for social clubs from

inappropriate application of the Change in Status Rule.

A number of commentators urged exempting newly formed social clubs

from the application of the regulations if they become tax-exempt

within seven years of their formation, rather than within the three-

year period provided for other tax-exempt entities. Those commentators

explained that some social clubs are organized when a real estate

developer acquires land to be used for a housing development and a

social club for the homeowners. The assets of the future social club

are held by a corporation, but it cannot qualify as a tax-exempt

section 501(c)(7) organization until several years later, after the

stock or membership interests in the corporation have been transferred

to the homeowners. Commentators familiar with development practices

advised that it often takes up to seven years to transfer the club to

the members' control. Furthermore, because the developer is forming the

club as a business venture, the developer will work to realize the

increase in the value of the club's assets as part of the transfer. For

these reasons, providing additional time for newly-formed clubs to

become tax-exempt does not conflict with General Utilities repeal.

Therefore, the final regulations incorporate the recommendation made in

the comments and provide that a social club will not

[[Page 71594]]

be subject to the Change in Status Rule if it converts to tax-exempt

status within seven taxable years after the year in which it was

formed.

Two commentators suggested that the Change in Status Rule could

adversely affect a taxable property and casualty insurance company that

becomes tax-exempt as an organization described in section 501(c)(15)

when it encounters financial difficulties leading to conservation or

liquidation proceedings pursuant to authority granted by a state

regulatory agency. A taxable property or casualty insurance company

whose net written premiums or direct written premiums are $350,000 or

less for the taxable year is eligible to be exempt from tax under

section 501(c)(15). The final regulations provide an exception from the

Change in Status Rule if in a taxable year an insurance company becomes

an organization described in section 501(c)(15), and during that year

and all subsequent years in which it is exempt under that section, the

insurance company is the subject of a court supervised rehabilitation,

conservatorship, liquidation, or similar state proceeding. In such

cases, the reduction in premium income to $350,000 or less is likely to

be involuntary and a direct result of the state proceeding. However,

the final regulations continue to apply the Change in Status Rule to

all other insurance companies qualifying for tax exemption under

section 501(c)(15).

3. UBTI Rule

Some commentators asked how the UBTI Rule would apply when assets

that are transferred to a tax-exempt entity are used partly in an

activity of the organization the income from which is subject to tax

under section 511(a) (``section 511(a) activity'') and partly in other

activities. The UBTI Rule in the proposed regulations defers gain

recognition with respect to those assets that will be used in a section

511(a) activity of the tax-exempt entity after the asset is transferred

to the tax-exempt entity or after the taxable corporation converts to

tax-exempt status. The final regulations provide that, if an asset will

be used partly or wholly in a section 511(a) activity of a tax-exempt

entity, the taxable corporation will recognize an amount of gain or

loss that bears the same ratio to the asset's built-in gain or loss as

100 percent reduced by the percentage of use in the section 511(a)

activity bears to 100 percent. The taxable corporation generally may

rely on a written representation from the tax-exempt entity as to the

anticipated percentage of use of the asset in a section 511(a) activity

during the first taxable year after the transfer or change in status.

If the percentage of an asset's use in the section 511(a) activity

later decreases from the estimate used in computing gain or loss when

the asset was transferred, the tax-exempt entity will recognize part of

the deferred gain or loss in an amount that is proportionate to the

decrease in use in the section 511(a) activity, and the gain or loss

recognized will be subject to tax under section 511(a). The tax-exempt

entity must use the same reasonable method of allocation for

determining the percentage it uses assets in the section 511(a)

activity for purposes of the UBTI Rule as it uses for other tax

purposes (e.g., depreciation deductions). The tax-exempt entity also

must use this same reasonable method of allocation for each taxable

year that it holds the assets.

One commentator asked that gain not be recognized when a tax-exempt

entity disposes of an asset used in a section 511(a) activity in a

transaction eligible for nonrecognition treatment under the Code. The

proposed regulations provide that gain is recognized on such

dispositions ``notwithstanding any other provision of law,''

corresponding with the rule in section 337(b)(2)(B)(ii), and overruling

the application of nonrecognition provisions such as section 512(b)(5).

In response to these comments, the final regulations allow continuing

deferral to the extent that the tax-exempt entity disposes of assets in

a transaction that qualifies for nonrecognition of gain or loss under

section 1031 or section 1033, but only to the extent that the

replacement asset is used in a section 511(a) activity. No exception is

made with respect to other nonrecognition provisions.

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 also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations. It is hereby certified that the

collection of information in these regulations will not have a

significant economic impact on a substantial number of small entities.

This certification is based upon the Internal Revenue Service's

estimate that only 25 entities per year will be responding to the

collection of information, and that the total annual reporting burden

of this information collection for all responding entities will be only

125 hours. Therefore, a Regulatory Flexibility Analysis under the

Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

Pursuant to section 7805(f), the notice of proposed rulemaking

preceding these regulations was submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on its impact

on small business.

Drafting Information

The principal author of these regulations is Stephen R. Cleary of

the Office of Assistant Chief Counsel (Corporate), IRS. However, other

personnel from the IRS and Treasury Department participated in their

development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

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 citation for 26 CFR Part 1 is amended by

adding an entry in numerical order to read as follows:

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

Section 1.337(d)-4 also issued under 26 U.S.C. 337. * * *

Par. 2. Section 1.337(d)-4 is added to read as follows:

Sec. 1.337(d)-4 Taxable to tax-exempt.

(a) Gain or loss recognition--(1) General rule. Except as provided

in paragraph (b) of this section, if a taxable corporation transfers

all or substantially all of its assets to one or more tax-exempt

entities, the taxable corporation must recognize gain or loss

immediately before the transfer as if the assets transferred were sold

at their fair market values. But see section 267 and paragraph (d) of

this section concerning limitations on the recognition of loss.

(2) Change in corporation's tax status treated as asset transfer.

Except as provided in paragraphs (a)(3) and (b) of this section, a

taxable corporation's change in status to a tax-exempt entity will be

treated as if it transferred all of its assets to a tax-exempt entity

immediately before the change in status becomes effective in a

transaction to which paragraph (a)(1) of this section applies. For

example, if a state, a political subdivision thereof, or an entity any

portion of whose income is excluded from gross income under

[[Page 71595]]

section 115, acquires the stock of a taxable corporation and thereafter

any of the taxable corporation's income is excluded from gross income

under section 115, the taxable corporation will be treated as if it

transferred all of its assets to a tax-exempt entity immediately before

the stock acquisition.

(3) Exceptions for certain changes in status--(i) To whom

available. Paragraph (a)(2) of this section does not apply to the

following corporations--

(A) A corporation previously tax-exempt under section 501(a) which

regains its tax-exempt status under section 501(a) within three years

from the later of a final adverse adjudication on the corporation's tax

exempt status, or the filing by the corporation, or by the Secretary or

his delegate under section 6020(b), of a federal income tax return of

the type filed by a taxable corporation;

(B) A corporation previously tax-exempt under section 501(a) or

that applied for but did not receive recognition of exemption under

section 501(a) before January 15, 1997, if such corporation is tax-

exempt under section 501(a) within three years from January 28, 1999;

(C) A newly formed corporation that is tax-exempt under section

501(a) (other than an organization described in section 501(c)(7))

within three taxable years from the end of the taxable year in which it

was formed;

(D) A newly formed corporation that is tax-exempt under section

501(a) as an organization described in section 501(c)(7) within seven

taxable years from the end of the taxable year in which it was formed;

(E) A corporation previously tax-exempt under section 501(a) as an

organization described in section 501(c)(12), which, in a given taxable

year or years prior to again becoming tax-exempt, is a taxable

corporation solely because less than 85 percent of its income consists

of amounts collected from members for the sole purpose of meeting

losses and expenses; if, in a taxable year, such a corporation would be

a taxable corporation even if 85 percent or more of its income consists

of amounts collected from members for the sole purpose of meeting

losses and expenses (a non-85 percent violation), paragraph

(a)(3)(i)(A) of this section shall apply as if the corporation became a

taxable corporation in its first taxable year that a non-85 percent

violation occurred; or

(F) A corporation previously taxable that becomes tax-exempt under

section 501(a) as an organization described in section 501(c)(15) if

during each taxable year in which it is described in section 501(c)(15)

the organization is the subject of a court supervised rehabilitation,

conservatorship, liquidation, or similar state proceeding; if such a

corporation continues to be described in section 501(c)(15) in a

taxable year when it is no longer the subject of a court supervised

rehabilitation, conservatorship, liquidation, or similar state

proceeding, paragraph (a)(2) of this section shall apply as if the

corporation first became tax-exempt for such taxable year.

(ii) Application for recognition. An organization is deemed to have

or regain tax-exempt status within one of the periods described in

paragraph (a)(3)(i)(A), (B), (C), or (D) of this section if it files an

application for recognition of exemption with the Commissioner within

the applicable period and the application either results in a

determination by the Commissioner or a final adjudication that the

organization is tax-exempt under section 501(a) during any part of the

applicable period. The preceding sentence does not require the filing

of an application for recognition of exemption by any organization not

otherwise required, such as by Sec. 1.501(a)-1, Sec. 1.505(c)-1T, and

Sec. 1.508-1(a), to apply for recognition of exemption.

(iii) Anti-abuse rule. This paragraph (a)(3) does not apply to a

corporation that, with a principal purpose of avoiding the application

of paragraph (a)(1) or (a)(2) of this section, acquires all or

substantially all of the assets of another taxable corporation and then

changes its status to that of a tax-exempt entity.

(4) Related transactions. This section applies to any series of

related transactions having an effect similar to any of the

transactions to which this section applies.

(b) Exceptions. Paragraph (a) of this section does not apply to--

(1) Any assets transferred to a tax-exempt entity to the extent

that the assets are used in an activity the income from which is

subject to tax under section 511(a) (referred to hereinafter as a

``section 511(a) activity''). However, if assets used to any extent in

a section 511(a) activity are disposed of by the tax-exempt entity,

then, notwithstanding any other provision of law (except section 1031

or section 1033), any gain (not in excess of the amount not recognized

by reason of the preceding sentence) shall be included in the tax-

exempt entity's unrelated business taxable income. To the extent that

the tax-exempt entity ceases to use the assets in a section 511(a)

activity, the entity will be treated for purposes of this paragraph

(b)(1) as having disposed of the assets on the date of the cessation

for their fair market value. For purposes of paragraph (a)(1) of this

section and this paragraph (b)(1)--

(i) If during the first taxable year following the transfer of an

asset or the corporation's change to tax-exempt status the asset will

be used by the tax-exempt entity partly or wholly in a section 511(a)

activity, the taxable corporation will recognize an amount of gain or

loss that bears the same ratio to the asset's built-in gain or loss as

100 percent reduced by the percentage of use for such taxable year in

the section 511(a) activity bears to 100 percent. For purposes of

determining the gain or loss, if any, to be recognized, the taxable

corporation may rely on a written representation from the tax-exempt

entity estimating the percentage of the asset's anticipated use in a

section 511(a) activity for such taxable year, using a reasonable

method of allocation, unless the taxable corporation has reason to

believe that the tax-exempt entity's representation is not made in good

faith;

(ii) If for any taxable year the percentage of an asset's use in a

section 511(a) activity decreases from the estimate used in computing

gain or loss recognized under paragraph (b)(1)(i) of this section,

adjusted for any decreases taken into account under this paragraph

(b)(1)(ii) in prior taxable years, the tax-exempt entity shall

recognize an amount of gain or loss that bears the same ratio to the

asset's built-in gain or loss as the percentage point decrease in use

in the section 511(a) activity for the taxable year bears to 100

percent;

(iii) If property on which all or a portion of the gain or loss is

not recognized by reason of the first sentence of paragraph (b)(1) of

this section is disposed of in a transaction that qualifies for

nonrecognition treatment under section 1031 or section 1033, the tax-

exempt entity must treat the replacement property as remaining subject

to paragraph (b)(1) of this section to the extent that the exchanged or

involuntarily converted property was so subject;

(iv) The tax-exempt entity must use the same reasonable method of

allocation for determining the percentage that it uses the assets in a

section 511(a) activity as it uses for other tax purposes, such as

determining the amount of depreciation deductions. The tax-exempt

entity also must use this same reasonable method of allocation for each

taxable year that it holds the assets; and

(v) An asset's built-in gain or loss is the amount that would be

recognized

[[Page 71596]]

under paragraph (a)(1) of this section except for this paragraph

(b)(1);

(2) Any transfer of assets to the extent gain or loss otherwise is

recognized by the taxable corporation on the transfer. See, for

example, sections 336, 337(b)(2), 367, and 1001;

(3) Any transfer of assets to the extent the transaction qualifies

for nonrecognition treatment under section 1031 or section 1033; or

(4) Any forfeiture of a taxable corporation's assets in a criminal

or civil action to the United States, the government of a possession of

the United States, a state, the District of Columbia, the government of

a foreign country, or a political subdivision of any of the foregoing;

or any expropriation of a taxable corporation's assets by the

government of a foreign country.

(c) Definitions. For purposes of this section:

(1) Taxable corporation. A taxable corporation is any corporation

that is not a tax-exempt entity as defined in paragraph (c)(2) of this

section.

(2) Tax-exempt entity. A tax-exempt entity is--

(i) Any entity that is exempt from tax under section 501(a) or

section 529;

(ii) A charitable remainder annuity trust or charitable remainder

unitrust as defined in section 664(d);

(iii) The United States, the government of a possession of the

United States, a state, the District of Columbia, the government of a

foreign country, or a political subdivision of any of the foregoing;

(iv) An Indian Tribal Government as defined in section 7701(a)(40),

a subdivision of an Indian Tribal Government determined in accordance

with section 7871(d), or an agency or instrumentality of an Indian

Tribal Government or subdivision thereof;

(v) An Indian Tribal Corporation organized under section 17 of the

Indian Reorganization Act of 1934, 25 U.S.C. 477, or section 3 of the

Oklahoma Welfare Act, 25 U.S.C. 503;

(vi) An international organization as defined in section

7701(a)(18);

(vii) An entity any portion of whose income is excluded under

section 115; or

(viii) An entity that would not be taxable under the Internal

Revenue Code for reasons substantially similar to those applicable to

any entity listed in this paragraph (c)(2) unless otherwise explicitly

made exempt from the application of this section by statute or by

action of the Commissioner.

(3) Substantially all. The term substantially all has the same

meaning as under section 368(a)(1)(C).

(d) Loss limitation rule. For purposes of determining the amount of

gain or loss recognized by a taxable corporation on the transfer of its

assets to a tax-exempt entity under paragraph (a) of this section, if

assets are acquired by the taxable corporation in a transaction to

which section 351 applied or as a contribution to capital, or assets

are distributed from the taxable corporation to a shareholder or

another member of the taxable corporation's affiliated group, and in

either case such acquisition or distribution is made as part of a plan

a principal purpose of which is to recognize loss by the taxable

corporation on the transfer of such assets to the tax-exempt entity,

the losses recognized by the taxable corporation on such assets

transferred to the tax-exempt entity will be disallowed. For purposes

of the preceding sentence, the principles of section 336(d)(2) apply.

(e) Effective date. This section is applicable to transfers of

assets as described in paragraph (a) of this section occurring after

January 28, 1999, unless the transfer is pursuant to a written

agreement which is (subject to customary conditions) binding on or

before January 28, 1999.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 4. In Sec. 602.101, paragraph (c) is amended by adding an

entry in numerical order to the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

------------------------------------------------------------------------

Current OMB

CFR part or section where identified and described control No.

------------------------------------------------------------------------

* * * * *

1.337(d)-4................................................. 1545-1633

* * * * *

------------------------------------------------------------------------

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

Approved: December 17, 1998.

Dated: December 17, 1998.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 98-34210 Filed 12-28-98; 8:45 am]

BILLING CODE 4830-01-P