Installment Obligations Received From Liquidating Corporations

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8762] RIN 1545-AB43

TITLE: Installment Obligations Received From Liquidating
Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the
use of the installment method to report the gain recognized by a
shareholder who receives, in exchange for the shareholder's stock,
certain installment obligations that are distributed upon the
complete liquidation of a corporation. Changes to the applicable tax
law were made by the Installment Sales Revision Act of 1980 and the
Tax Reform Act of 1986. These regulations affect taxpayers who
receive installment obligations in exchange for their stock upon the
complete liquidation of a corporation.

DATES: This regulation is effective January 28, 1998.

For dates of applicability, see §1.453-11(e) of these regulations.

FOR FURTHER INFORMATION CONTACT: George F. Wright, (202) 622- 4950
(not a toll-free number).

SUPPLEMENTARY INFORMATION

Background

Section 453(h), relating to the tax treatment of installment
obligations received by a shareholder from a liquidating
corporation, was added to the Internal Revenue Code of 1954 by the
Installment Sales Revision Act of 1980, Public Law 96-471, 94 Stat.
2247, 2250. Proposed regulations under section 453(h) were published
in the Federal Register for January 13, 1984 (49 FR 1742).
Subsequently, section 453(h) was amended as part of the Tax Reform
Act of 1986, Public Law 99-514, 100 Stat. 2085, 2274, pursuant to
which both C and S corporations became subject to tax upon making
liquidating distributions of installment obligations to
shareholders. The Technical and Miscellaneous Revenue Act of 1988,
Public Law 100-647, 102 Stat. 3342, 3403, added section 453B(h),
which provides that no gain or loss is recognized by S corporations
with respect to certain liquidating distributions of installment
obligations. The regulations proposed on January 13, 1984 (49 FR
1742), were withdrawn by the notice of proposed rulemaking published
on January 22, 1997 (62 FR 3244), except for paragraph (e) relating
to liquidating distributions received in more than one taxable year,
and paragraph (g) containing the effective date provision. The
notice of proposed rulemaking published in the Federal Register for
January 22, 1997, reserved paragraph (d) for liquidating
distributions received in more than one taxable year. Written
comments responding to this notice were received. No public hearing
was held because no hearing was requested. After consideration of
all comments received, the proposed regulations are adopted as
revised by this Treasury decision.

Explanation of Provisions

A. Overview of Provisions

Prior to the Installment Sales Revision Act of 1980, a shareholder
recognized gain or loss on receipt of an installment obligation that
was distributed by a liquidating corporation in exchange for the
shareholder's stock. Gain could not be reported under the
installment sale provisions of section 453 as payments were received
on the obligation distributed by the corporation in the liquidation.

As enacted by the Installment Sales Revision Act of 1980 and amended
by the Tax Reform Act of 1986, section 453(h) provides a different
treatment for certain installment obligations that are distributed
in a complete liquidation to which section 331 applies. Under
section 453(h), a shareholder that does not elect out of the
installment method treats the payments under the obligation, rather
than the obligation itself, as consideration received in exchange
for the stock. The shareholder then takes into account the income
from the payments under the obligation using the installment method.
In this manner, the shareholder generally is treated as if the
shareholder sold the shareholder's stock to an unrelated purchaser
on the installment method.

This treatment under section 453(h) applies generally to installment
obligations received by a shareholder (in exchange for the
shareholder's stock) in a complete liquidation to which section 331
applies if (a) the installment obligations are qualifying
installment obligations, i.e., the installment obligations are
acquired in respect of a sale or exchange of property by the
corporation during the 12-month period beginning on the date a plan
of complete liquidation is adopted, and (b) the liquidation is
completed within that 12-month period.

However, an installment obligation acquired in a sale or exchange of
inventory, stock in trade, or property held for sale in the ordinary
course of business qualifies for this treatment only if the
obligation arises from a single bulk sale of substantially all of
such property attributable to a trade or business of the
corporation. If an installment obligation arises from both a sale or
exchange of inventory, etc., that does not comply with the
requirements of the preceding sentence and a sale or exchange of
other assets, the portion of the installment obligation that is
attributable to the sale or exchange of other assets is a qualifying
installment obligation.

B. Discussion of Comments

Interaction of section 453(h) and limitations on the installment
method

The regulations provide that, if the stock of a liquidating
corporation is traded on an established securities market, an
installment obligation received by a shareholder from that
corporation as a liquidating distribution is not a qualifying
installment obligation and does not qualify for installment
reporting, regardless of whether the requirements of section 453(h)
are otherwise satisfied. However, if an installment obligation is
received by a shareholder from a liquidating corporation whose stock
is not publicly traded, and the obligation arose from a sale by the
corporation of stock or securities that are traded on an established
market, then the obligation generally is a qualifying installment
obligation in the hands of the transferor. An exception to the above
rule applies if the liquidating corporation is formed or availed of
for a principal purpose of avoiding limitations on the availability
of installment sales treatment, such as section 453(k), through the
use of a related party.

One commentator suggested that the anti-abuse rule directed at cases
in which there is a principal purpose to avoid section 453(k) is not
necessary. The commentator suggests that the effect of a
contribution of publicly-traded stock to a nonpublicly-traded
corporation, followed by the sale of the publicly-traded stock for
an installment obligation and the liquidation of the nonpublicly-
traded corporation, is the creation of two levels of tax because the
liquidating corporation must recognize gain on the distribution of
the installment obligation. Accordingly, the commentator does not
believe that the transaction offers any tax avoidance opportunities
that warrant a specific anti-abuse rule.

The anti-abuse rule is directed at circumvention of the prohibition
in section 453(k) against the use of the installment method for a
sale of publicly-traded securities. It is designed to prevent a
shareholder from indirectly entering into such a sale on the
installment method when the shareholder could not have done so
through a direct sale. Accordingly, the anti-abuse rule has been
retained.

Liquidating distributions received in more than one year Under
§1.453-2(e) proposed on January 13, 1984, if liquidating
distributions, including qualifying installment obligations, are
received in more than one taxable year, a shareholder must file an
amended return if the reallocation of basis required under section
453(h)(2) affects the computation of gain recognized in an earlier
year. If the shareholder has transferred the installment obligation
to a person whose basis in the obligation is determined by reference
to the shareholder's basis, then the transferee generally is
required to reallocate basis and, if necessary, file an amended
return. The proposed effective date applied to distributions of
qualifying installment obligations made after March 31, 1980.

In the preamble to the 1997 proposed regulations, the IRS and
Treasury Department suggested that an alternative to the amended
return requirement would be to require the shareholder to recognize
in the current year the additional amount of gain that would have
been recognized in the earlier year had the total amount of the
liquidating distributions been known in the earlier year. Comments
were requested regarding these and any other methods of
accomplishing the basis reallocation. Proposed §1.453-11(d) relating
to liquidating distributions received in more than one taxable year
was reserved.

One commentator questioned whether amended returns were necessary
and noted that the alternative method discussed in the preamble is
simpler and less burdensome for taxpayers. The commentator then
suggested an ordering rule as another method of achieving the
intended purpose. Under the proposed ordering rule, basis first
would be allocated to assets other than installment obligations
distributed in the liquidation with the remainder allocated to the
installment obligations. The commentator acknowledged that it might
not be appropriate to implement this approach by regulation without
amending the statute.

The proposed ordering rule does not satisfy the basis reallocation
requirement of section 453(h)(2) and would require complex
provisions to implement it. Accordingly, the suggested approach is
not adopted in the final regulations.

The purpose underlying section 453(h)(2) is to ensure that gain is
recognized in the appropriate year when liquidating distributions
are received in more than one taxable year. The IRS and Treasury
Department believe that this purpose can be substantially fulfilled
without imposing the burden of filing amended returns. Accordingly,
the final regulations incorporate a current-year recognition rule.
Under the current-year recognition rule, a shareholder is required
to recognize in the current year the additional amount of gain that
would have been recognized in the earlier year had the total amount
of the liquidating distributions been known in the earlier year. In
allocating basis to calculate the gain to be reported in the first
year in which a liquidating distribution is received, a shareholder
is required to reasonably estimate the anticipated aggregate
distributions. For this purpose, the shareholder must take into
account distributions and other events occurring up to the time at
which the return for the first taxable year is filed.

Section §1.453-2(e) of the 1984 proposal is adopted as revised by
this Treasury decision. The effective date provision in §1.453- 2(g)
of the proposal is not adopted.

Recognition of gain or loss to the distributing corporation under
section 453B

Under section 453B, the disposition of an installment obligation
generally results in the recognition of gain or loss to the
transferor. Thus, in accordance with sections 453B and 336, a C
corporation generally recognizes gain or loss upon the distribution
of an installment obligation to a shareholder in exchange for the
shareholder's stock, including complete liquidations covered by
section 453(h). Section 453B(d) provides an exception to this
general rule if the installment obligation is distributed in a
liquidation to which section 337(a) applies (regarding certain
complete liquidations of 80 percent or more owned subsidiaries).
However, that exception does not apply to liquidations under section
331.

In the case of a liquidating distribution by an S corporation,
however, section 453B(h) provides that if an S corporation
distributes an installment obligation in exchange for a
shareholder's stock, and payments under the obligation are treated
as consideration for the stock pursuant to section 453(h)(1), then
the distribution generally is not treated as a disposition of the
obligation by the S corporation. Thus, except for purposes of
sections 1374 and 1375 (relating to certain built-in gains and
passive investment income), the S corporation does not recognize
gain or loss on the distribution of the installment obligation to a
shareholder in a complete liquidation covered by section 453(h). One
commentator believed that it is inequitable to allow a shareholder
to recognize gain on the installment basis while the liquidating C
corporation has immediate recognition upon distribution of an
obligation. As an alternative, the commentator suggested that the
corporation's tax liability arising from the distribution of an
obligation carry over to the shareholders and be taken into account
by them as payments are received on the obligation. The suggested
approach would be inconsistent with the statutory provisions of
sections 336 and 453B and, accordingly, is not adopted in the final
regulations.

Another commentator requested that the regulations provide relief
from a bunching of income that occurs for shareholders receiving
liquidating distributions from S corporations. The bunching can
occur, for example, by virtue of the interrelationship of the S
corporation and installment sale provisions if, in the year in which
assets are sold, an S corporation receives a payment on an
installment obligation arising from the sale before the corporation
liquidates. The commentator suggested that the regulations allow a
shareholder first to apply the basis in the stock against the
initial payment received, with any remaining basis allocated to any
additional payments to be received. Since the bunching of income
results from the successive application of section 453(c) at the
corporate and shareholder levels and no statutory exception for
shareholders of S corporations is provided, this issue cannot be
appropriately addressed in these final regulations.

Incorporation of guidance on section 338(h)(10) elections Three
commentators suggested that the regulations be expanded to address
the use of the installment method to the sale of stock of a
corporation with respect to which an election under section 338(h)
(10) has been made. This issue does not arise under section 453(h)
and is beyond the scope of these regulations.

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, and because the
regulations do not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Pursuant to section 7805(f) of the
Internal Revenue Code, 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 George F.

Wright of the Office of Assistant Chief Counsel (Income Tax and
Accounting). 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.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:

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

§1.453-11 also issued under 26 U.S.C. 453(j)(1) and (k). * * *

Par. 2. Section 1.453-11 is added to read as follows:

§1.453-11 Installment obligations received from a liquidating
corporation.

(a) In general--(1) Overview. Except as provided in section 453(h)
(1)(C) (relating to installment sales of depreciable property to
certain closely related persons), a qualifying shareholder (as
defined in paragraph (b) of this section) who receives a qualifying
installment obligation (as defined in paragraph (c) of this section)
in a liquidation that satisfies section 453(h)(1)(A) treats the
receipt of payments in respect of the obligation, rather than the
receipt of the obligation itself, as a receipt of payment for the
shareholder's stock. The shareholder reports the payments received
on the installment method unless the shareholder elects otherwise in
accordance with §15a.453-1(d) of this chapter.

(2) Coordination with other provisions--(i) Deemed sale of stock for
installment obligation. Except as specifically provided in section
453(h)(1)(C), a qualifying shareholder treats a qualifying
installment obligation, for all purposes of the Internal Revenue
Code, as if the obligation is received by the shareholder from the
person issuing the obligation in exchange for the shareholder's
stock in the liquidating corporation. For example, if the stock of a
corporation that is liquidating is traded on an established
securities market, an installment obligation distributed to a
shareholder of the corporation in exchange for the shareholder's
stock does not qualify for installment reporting pursuant to section
453(k)(2).

(ii) Special rules to account for the qualifying installment
obligation--(A) Issue price. A qualifying installment obligation is
treated by a qualifying shareholder as newly issued on the date of
the distribution. The issue price of the qualifying installment
obligation on that date is equal to the sum of the adjusted issue
price of the obligation on the date of the distribution (as
determined under §1.1275-1(b)) and the amount of any qualified
stated interest (as defined in §1.1273-1(c)) that has accrued prior
to the distribution but that is not payable until after the
distribution. For purposes of the preceding sentence, if the
qualifying installment obligation is subject to §1.446-2 (e.g., a
debt instrument that has unstated interest under section 483), the
adjusted issue price of the obligation is determined under
§1.446-2(c) and (d).

(B) Variable rate debt instrument. If the qualifying installment
obligation is a variable rate debt instrument (as defined in
§1.1275-5), the shareholder uses the equivalent fixed rate debt
instrument (within the meaning of §1.1275-5(e)(3)(ii)) constructed
for the qualifying installment obligation as of the date the
obligation was issued to the liquidating corporation to determine
the accruals of original issue discount, if any, and interest on the
obligation.

(3) Liquidating distributions treated as selling price. All amounts
distributed or treated as distributed to a qualifying shareholder
incident to the liquidation, including cash, the issue price of
qualifying installment obligations as determined under paragraph (a)
(2)(ii)(A) of this section, and the fair market value of other
property (including obligations that are not qualifying installment
obligations) are considered as having been received by the
shareholder as the selling price (as defined in §15a.453-1(b)(2)(ii)
of this chapter) for the shareholder's stock in the liquidating
corporation. For the proper method of reporting liquidating
distributions received in more than one taxable year of a
shareholder, see paragraph (d) of this section.

An election not to report on the installment method an installment
obligation received in the liquidation applies to all distributions
received in the liquidation.

(4) Assumption of corporate liability by shareholders. For purposes
of this section, if in the course of a liquidation a shareholder
assumes secured or unsecured liabilities of the liquidating
corporation, or receives property from the corporation subject to
such liabilities (including any tax liabilities incurred by the
corporation on the distribution), the amount of the liabilities is
added to the shareholder's basis in the stock of the liquidating
corporation. These additions to basis do not affect the
shareholder's holding period for the stock. These liabilities do not
reduce the amounts received in computing the selling price.

(5) Examples. The provisions of this paragraph (a) are illustrated
by the following examples. Except as otherwise provided, assume in
each example that A, an individual who is a calendar-year taxpayer,
owns all of the stock of T corporation.

A's adjusted tax basis in that stock is $100,000. On February 1,
1998, T, an accrual method taxpayer, adopts a plan of complete
liquidation that satisfies section 453(h)(1)(A) and immediately
sells all of its assets to unrelated B corporation in a single
transaction. The examples are as follows:

Example 1. (i) The stated purchase price for T's assets is
$3,500,000. In consideration for the sale, B makes a down payment of
$500,000 and issues a 10-year installment obligation with a stated
principal amount of $3,000,000. The obligation provides for interest
payments of $150,000 on January 31 of each year, with the total
principal amount due at maturity.

(ii) Assume that for purposes of section 1274, the test rate on
February 1, 1998, is 8 percent, compounded semi-annually.

Also assume that a semi-annual accrual period is used. Under
§1.1274-2, the issue price of the obligation on February 1, 1998, is
$2,368,450. Accordingly, the obligation has $631,550 of original
issue discount ($3,000,000 - $2,368,450). Between February 1 and
July 31, $19,738 of original issue discount and $75,000 of qualified
stated interest accrue with respect to the obligation and are taken
into account by T.

(iii) On July 31, 1998, T distributes the installment obligation to
A in exchange for A's stock. No other property is ever distributed
to A. On January 31, 1999, A receives the first annual payment of
$150,000 from B.

(iv) When the obligation is distributed to A on July 31, 1998, it is
treated as if the obligation is received by A in an installment sale
of shares directly to B on that date. Under §1.1275-1(b), the
adjusted issue price of the obligation on that date is $2,388,188
(original issue price of $2,368,450 plus accrued original issue
discount of $19,738). Accordingly, the issue price of the obligation
under paragraph (a)(2)(ii)(A) of this section is $2,463,188, the sum
of the adjusted issue price of the obligation on that date
($2,388,188) and the amount of accrued but unpaid qualified stated
interest ($75,000).

(v) The selling price and contract price of A's stock in T is
$2,463,188, and the gross profit is $2,363,188 ($2,463,188 selling
price less A's adjusted tax basis of $100,000). A's gross profit
ratio is thus 96 percent (gross profit of $2,363,188 divided by
total contract price of $2,463,188).

(vi) Under §§1.446-2(e)(1) and 1.1275-2(a), $98,527 of the $150,000
payment is treated as a payment of the interest and original issue
discount that accrued on the obligation from July 31, 1998, to
January 31, 1999 ($75,000 of qualified stated interest and $23,527
of original issue discount). The balance of the payment ($51,473) is
treated as a payment of principal. A's gain recognized in 1999 is
$49,414 (96 percent of $51,473).

Example 2. (i) T owns Blackacre, unimproved real property, with an
adjusted tax basis of $700,000. Blackacre is subject to a mortgage
(underlying mortgage) of $1,100,000. A is not personally liable on
the underlying mortgage and the T shares held by A are not
encumbered by the underlying mortgage. The other assets of T consist
of $400,000 of cash and $600,000 of accounts receivable attributable
to sales of inventory in the ordinary course of business. The
unsecured liabilities of T total $900,000.

(ii) On February 1, 1998, T adopts a plan of complete liquidation
complying with section 453(h)(1)(A), and promptly sells Blackacre to
B for a 4-year mortgage note (bearing adequate stated interest and
otherwise meeting all of the requirements of section 453) in the
face amount of $4 million. Under the agreement between T and B, T
(or its successor) is to continue to make principal and interest
payments on the underlying mortgage.

Immediately thereafter, T completes its liquidation by distributing
to A its remaining cash of $400,000 (after payment of T's tax
liabilities), accounts receivable of $600,000, and the $4 million B
note. A assumes T's $900,000 of unsecured liabilities and receives
the distributed property subject to the obligation to make payments
on the $1,100,000 underlying mortgage. A receives no payments from B
on the B note during 1998.

(iii) Unless A elects otherwise, the transaction is reported by A on
the installment method. The selling price is $5 million (cash of
$400,000, accounts receivable of $600,000, and the B note of $4
million). The total contract price also is $5 million. A's adjusted
tax basis in the T shares, initially $100,000, is increased by the
$900,000 of unsecured T liabilities assumed by A and by the
obligation (subject to which A takes the distributed property) to
make payments on the $1,100,000 underlying mortgage on Blackacre,
for an aggregate adjusted tax basis of $2,100,000. Accordingly, the
gross profit is $2,900,000 (selling price of $5 million less
aggregate adjusted tax basis of $2,100,000). The gross profit ratio
is 58 percent (gross profit of $2,900,000 divided by the total
contract price of $5 million).

The 1998 payments to A are $1 million ($400,000 cash plus $600,000
receivables) and A recognizes gain in 1998 of $580,000 (58 percent
of $1 million).

(iv) In 1999, A receives payment from B on the B note of $1 million
(exclusive of interest). A's gain recognized in 1999 is $580,000 (58
percent of $1 million).

(b) Qualifying shareholder. For purposes of this section, qualifying
shareholder means a shareholder to which, with respect to the
liquidating distribution, section 331 applies. For example, a
creditor that receives a distribution from a liquidating
corporation, in exchange for the creditor's claim, is not a
qualifying shareholder as a result of that distribution regardless
of whether the liquidation satisfies section 453(h)(1)(A).

(c) Qualifying installment obligation--(1) In general. For purposes
of this section, qualifying installment obligation means an
installment obligation (other than an evidence of indebtedness
described in §15a.453-1(e) of this chapter, relating to obligations
that are payable on demand or are readily tradable) acquired in a
sale or exchange of corporate assets by a liquidating corporation
during the 12-month period beginning on the date the plan of
liquidation is adopted. See paragraph (c)(4) of this section for an
exception for installment obligations acquired in respect of certain
sales of inventory.

Also see paragraph (c)(5) of this section for an exception for
installment obligations attributable to sales of certain property
that do not generally qualify for installment method treatment.

(2) Corporate assets. Except as provided in section 453(h)(1)(C), in
paragraph (c)(4) of this section (relating to certain sales of
inventory), and in paragraph (c)(5) of this section (relating to
certain tax avoidance transactions), the nature of the assets sold
by, and the tax consequences to, the selling corporation do not
affect whether an installment obligation is a qualifying installment
obligation. Thus, for example, the fact that the fair market value
of an asset is less than the adjusted basis of that asset in the
hands of the corporation; or that the sale of an asset will subject
the corporation to depreciation recapture (e.g., under section 1245
or section 1250); or that the assets of a trade or business sold by
the corporation for an installment obligation include depreciable
property, certain marketable securities, accounts receivable,
installment obligations, or cash; or that the distribution of assets
to the shareholder is or is not taxable to the corporation under
sections 336 and 453B, does not affect whether installment
obligations received in exchange for those assets are treated as
qualifying installment obligations by the shareholder. However, an
obligation received by the corporation in exchange for cash, in a
transaction unrelated to a sale or exchange of noncash assets by the
corporation, is not treated as a qualifying installment obligation.

(3) Installment obligations distributed in liquidations described in
section 453(h)(1)(E)--(i) In general. In the case of a liquidation
to which section 453(h)(1)(E) (relating to certain liquidating
subsidiary corporations) applies, a qualifying installment
obligation acquired in respect of a sale or exchange by the
liquidating subsidiary corporation will be treated as a qualifying
installment obligation if distributed by a controlling corporate
shareholder (within the meaning of section 368(c)) to a qualifying
shareholder. The preceding sentence is applied successively to each
controlling corporate shareholder, if any, above the first
controlling corporate shareholder.

(ii) Examples. The provisions of this paragraph (c)(3) are
illustrated by the following examples:

Example 1. (i) A, an individual, owns all of the stock of T
corporation, a C corporation. T has an operating division and three
wholly-owned subsidiaries, X, Y, and Z. On February 1, 1998, T, Y,
and Z all adopt plans of complete liquidation.

(ii) On March 1, 1998, the following sales are made to unrelated
purchasers: T sells the assets of its operating division to B for
cash and an installment obligation. T sells the stock of X to C for
an installment obligation. Y sells all of its assets to D for an
installment obligation. Z sells all of its assets to E for cash. The
B, C, and D installment obligations bear adequate stated interest
and meet the requirements of section 453.

(iii) In June 1998, Y and Z completely liquidate, distributing their
respective assets (the D installment obligation and cash) to T. In
July 1998, T completely liquidates, distributing to A cash and the
installment obligations respectively issued by B, C, and D. The
liquidation of T is a liquidation to which section 453(h) applies
and the liquidations of Y and Z into T are liquidations to which
section 332 applies.

(iv) Because T is in control of Y (within the meaning of section
368(c)), the D obligation acquired by Y is treated as acquired by T
pursuant to section 453(h)(1)(E). A is a qualifying shareholder and
the installment obligations issued by B, C, and D are qualifying
installment obligations. Unless A elects otherwise, A reports the
transaction on the installment method as if the cash and installment
obligations had been received in an installment sale of the stock of
T corporation.

Under section 453B(d), no gain or loss is recognized by Y on the
distribution of the D installment obligation to T. Under sections
453B(a) and 336, T recognizes gain or loss on the distribution of
the B, C, and D installment obligations to A in exchange for A's
stock.

Example 2. (i) A, a cash-method individual taxpayer, owns all of the
stock of P corporation, a C corporation. P owns 30 percent of the
stock of Q corporation. The balance of the Q stock is owned by
unrelated individuals. On February 1, 1998, P adopts a plan of
complete liquidation and sells all of its property, other than its Q
stock, to B, an unrelated purchaser for cash and an installment
obligation bearing adequate stated interest. On March 1, 1998, Q
adopts a plan of complete liquidation and sells all of its property
to an unrelated purchaser, C, for cash and installment obligations.
Q immediately distributes the cash and installment obligations to
its shareholders in completion of its liquidation. Promptly
thereafter, P liquidates, distributing to A cash, the B installment
obligation, and a C installment obligation that P received in the
liquidation of Q.

(ii) In the hands of A, the B installment obligation is a qualifying
installment obligation. In the hands of P, the C installment
obligation was a qualifying installment obligation.

However, in the hands of A, the C installment obligation is not
treated as a qualifying installment obligation because P owned only
30 percent of the stock of Q. Because P did not own the requisite 80
percent stock interest in Q, P was not a controlling corporate
shareholder of Q (within the meaning of section 368(c)) immediately
before the liquidation. Therefore, section 453(h)(1)(E) does not
apply. Thus, in the hands of A, the C obligation is considered to be
a third-party note (not a purchaser's evidence of indebtedness) and
is treated as a payment to A in the year of distribution.
Accordingly, for 1998, A reports as payment the cash and the fair
market value of the C obligation distributed to A in the liquidation
of P.

(iii) Because P held 30 percent of the stock of Q, section 453B(d)
is inapplicable to P. Under sections 453B(a) and 336, accordingly, Q
recognizes gain or loss on the distribution of the C obligation. P
also recognizes gain or loss on the distribution of the B and C
installment obligations to A in exchange for A's stock. See sections
453B and 336.

(4) Installment obligations attributable to certain sales of
inventory--(i) In general. An installment obligation acquired by a
corporation in a liquidation that satisfies section 453(h)(1)(A) in
respect of a broken lot of inventory is not a qualifying installment
obligation. If an installment obligation is acquired in respect of a
broken lot of inventory and other assets, only the portion of the
installment obligation acquired in respect of the broken lot of
inventory is not a qualifying installment obligation. The portion of
the installment obligation attributable to other assets is a
qualifying installment obligation. For purposes of this section, the
term broken lot of inventory means inventory property that is sold
or exchanged other than in bulk to one person in one transaction
involving substantially all of the inventory property attributable
to a trade or business of the corporation. See paragraph (c)(4)(ii)
of this section for rules for determining what portion of an
installment obligation is not a qualifying installment obligation
and paragraph (c)(4)(iii) of this section for rules determining the
application of payments on an installment obligation only a portion
of which is a qualifying installment obligation.

(ii) Rules for determining nonqualifying portion of an installment
obligation. If a broken lot of inventory is sold to a purchaser
together with other corporate assets for consideration consisting of
an installment obligation and either cash, other property, the
assumption of (or taking property subject to) corporate liabilities
by the purchaser, or some combination thereof, the installment
obligation is treated as having been acquired in respect of a broken
lot of inventory only to the extent that the fair market value of
the broken lot of inventory exceeds the sum of unsecured liabilities
assumed by the purchaser, secured liabilities which encumber the
broken lot of inventory and are assumed by the purchaser or to which
the broken lot of inventory is subject, and the sum of the cash and
fair market value of other property received. This rule applies
solely for the purpose of determining the portion of the installment
obligation (if any) that is attributable to the broken lot of
inventory.

(iii) Application of payments. If, by reason of the application of
paragraph (c)(4)(ii) of this section, a portion of an installment
obligation is not a qualifying installment obligation, then for
purposes of determining the amount of gain to be reported by the
shareholder under section 453, payments on the obligation (other
than payments of qualified stated interest) shall be applied first
to the portion of the obligation that is not a qualifying
installment obligation.

(iv) Example. The following example illustrates the provisions of
this paragraph (c)(4). In this example, assume that all obligations
bear adequate stated interest within the meaning of section 1274(c)
(2) and that the fair market value of each nonqualifying installment
obligation equals its face amount.

The example is as follows:

Example. (i) P corporation has three operating divisions, X, Y, and
Z, each engaged in a separate trade or business, and a minor amount
of investment assets. On July 1, 1998, P adopts a plan of complete
liquidation that meets the criteria of section 453(h)(1)(A). The
following sales are promptly made to purchasers unrelated to P: P
sells all of the assets of the X division (including all of the
inventory property) to B for $30,000 cash and installment
obligations totalling $200,000. P sells substantially all of the
inventory property of the Y division to C for a $100,000 installment
obligation, and sells all of the other assets of the Y division
(excluding cash but including installment receivables previously
acquired in the ordinary course of the business of the Y division)
to D for a $170,000 installment obligation. P sells 1/3 of the
inventory property of the Z division to E for $100,000 cash, 1/3 of
the inventory property of the Z division to F for a $100,000
installment obligation, and all of the other assets of the Z
division (including the remaining 1/3 of the inventory property
worth $100,000) to G for $60,000 cash, a $240,000 installment
obligation, and the assumption by G of the liabilities of the Z
division. The liabilities assumed by G, which are unsecured
liabilities and liabilities encumbering the inventory property
acquired by G, aggregate $30,000. Thus, the total purchase price G
pays is $330,000.

(ii) P immediately completes its liquidation, distributing the cash
and installment obligations, which otherwise meet the requirements
of section 453, to A, an individual cash-method taxpayer who is its
sole shareholder. In 1999, G makes a payment to A of $100,000
(exclusive of interest) on the $240,000 installment obligation.

(iii) In the hands of A, the installment obligations issued by B, C,
and D are qualifying installment obligations because Face amount
$240,000.

1 they were timely acquired by P in a sale or exchange of its
assets. In addition, the installment obligation issued by C is a
qualifying installment obligation because it arose from a sale to
one person in one transaction of substantially all of the inventory
property of the trade or business engaged in by the Y division.

(iv) The installment obligation issued by F is not a qualifying
installment obligation because it is in respect of a broken lot of
inventory. A portion of the installment obligation issued by G is a
qualifying installment obligation and a portion is not a qualifying
installment obligation, determined as follows: G purchased part of
the inventory property (with a fair market value of $100,000) and
all of the other assets of the Z division by paying cash ($60,000),
issuing an installment obligation ($240,000), and assuming
liabilities of the Z division ($30,000). The assumed liabilities
($30,000) and cash ($60,000) are attributed first to the inventory
property. Therefore, only $10,000 of the $240,000 installment
obligation is attributed to inventory property. Accordingly, in the
hands of A, the G installment obligation is a qualifying installment
obligation to the extent of $230,000, but is not a qualifying
installment obligation to the extent of the $10,000 attributable to
the inventory property.

(v) In the 1998 liquidation of P, A receives a liquidating
distribution as follows:

             Qualifying Install-        Cash and
Item         ment Obligations           Other Property
cash                                    $190,000
B note       $200,000
C note       $100,000
D note       $170,000
F note                                  $100,000
G note 1     $230,000                   $ 10,000
Total        $700,000                   $300,000

(vi) Assume that A's adjusted tax basis in the stock of P is
$100,000. Under the installment method, A's selling price and the
contract price are both $1 million, the gross profit is $900,000
(selling price of $1 million less adjusted tax basis of $100,000),
and the gross profit ratio is 90 percent (gross profit of $900,000
divided by the contract price of $1 million).

Accordingly, in 1998, A reports gain of $270,000 (90 percent of
$300,000 payment in cash and other property). A's adjusted tax basis
in each of the qualifying installment obligations is an amount equal
to 10 percent of the obligation's respective face amount. A's
adjusted tax basis in the F note, a nonqualifying installment
obligation, is $100,000, i.e., the fair market value of the note
when received by A. A's adjusted tax basis in the G note, a mixed
obligation, is $33,000 (10 percent of the $230,000 qualifying
installment obligation portion of the note, plus the $10,000
nonqualifying portion of the note).

(vii) With respect to the $100,000 payment received from G in 1999,
$10,000 is treated as the recovery of the adjusted tax basis of the
nonqualifying portion of the G installment obligation and $9,000 (10
percent of $90,000) is treated as the recovery of the adjusted tax
basis of the portion of the note that is a qualifying installment
obligation. The remaining $81,000 (90 percent of $90,000) is
reported as gain from the sale of A's stock. See paragraph (c)(4)
(iii) of this section.

(5) Installment obligations attributable to sales of certain
property--(i) In general. An installment obligation acquired by a
liquidating corporation, to the extent attributable to the sale of
property described in paragraph (c)(5)(ii) of this section, is not a
qualifying obligation if the corporation is formed or availed of for
a principal purpose of avoiding section 453(b)(2) (relating to
dealer dispositions and certain other dispositions of personal
property), section 453(i) (relating to sales of property subject to
recapture), or section 453(k) (relating to dispositions under a
revolving credit plan and sales of stock or securities traded on an
established securities market) through the use of a party bearing a
relationship, either directly or indirectly, described in section
267(b) to any shareholder of the corporation.

(ii) Covered property. Property is described in this paragraph (c)
(5)(ii) if, within 12 months before or after the adoption of the
plan of liquidation, the property was owned by any shareholder and--

(A) The shareholder regularly sold or otherwise disposed of personal
property of the same type on the installment plan or the property is
real property that the shareholder held for sale to customers in the
ordinary course of a trade or business (provided the property is not
described in section 453(l)(2) (relating to certain exceptions to
the definition of dealer dispositions));

(B) The sale of the property by the shareholder would result in
recapture income (within the meaning of section 453(i)(2)), but only
if the amount of the recapture income is equal to or greater than 50
percent of the property's fair market value on the date of the sale
by the corporation;

(C) The property is stock or securities that are traded on an
established securities market; or

(D) The sale of the property by the shareholder would have been
under a revolving credit plan.

(iii) Safe harbor. Paragraph (c)(5)(i) of this section will not
apply to the liquidation of a corporation if, on the date the plan
of complete liquidation is adopted and thereafter, less than 15
percent of the fair market value of the corporation's assets is
attributable to property described in paragraph (c)(5)(ii) of this
section.

(iv) Example. The provisions of this paragraph (c)(5) are
illustrated by the following example:

Example. Ten percent of the fair market value of the assets of T is
attributable to stock and securities traded on an established
securities market. T owns no other assets described in paragraph (c)
(5)(ii) of this section. T, after adopting a plan of complete
liquidation, sells all of its stock and securities holdings to C
corporation in exchange for an installment obligation bearing
adequate stated interest, sells all of its other assets to B
corporation for cash, and distributes the cash and installment
obligation to its sole shareholder, A, in a complete liquidation
that satisfies section 453(h)(1)(A). Because the C installment
obligation arose from a sale of publicly traded stock and
securities, T cannot report the gain on the sale under the
installment method pursuant to section 453(k)(2). In the hands of A,
however, the C installment obligation is treated as having arisen
out of a sale of the stock of T corporation. In addition, the
general rule of paragraph (c)(5)(i) of this section does not apply,
even if a principal purpose of the liquidation was the avoidance of
section 453(k)(2), because the fair market value of the publicly
traded stock and securities is less than 15 percent of the total
fair market value of T's assets. Accordingly, section 453(k)(2) does
not apply to A, and A may use the installment method to report the
gain recognized on the payments it receives in respect of the
obligation.

(d) Liquidating distributions received in more than one taxable
year. If a qualifying shareholder receives liquidating distributions
to which this section applies in more than one taxable year, the
shareholder must reasonably estimate the gain attributable to
distributions received in each taxable year. In allocating basis to
calculate the gain for a taxable year, the shareholder must
reasonably estimate the anticipated aggregate distributions. For
this purpose, the shareholder must take into account distributions
and other relevant events or information that the shareholder knows
or reasonably could know up to the date on which the federal income
tax return for that year is filed. If the gain for a taxable year is
properly taken into account on the basis of a reasonable estimate
and the exact amount is subsequently determined the difference, if
any, must be taken into account for the taxable year in which the
subsequent determination is made. However, the shareholder may file
an amended return for the earlier year in lieu of taking the
difference into account for the subsequent taxable year.

(e) Effective date. This section is applicable to distributions of
qualifying installment obligations made on or after January 28,
1998.

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: December 18, 1997
Donald C. Lubick
Acting Assistant Secretary of the Treasury

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