§ 1.1502-32. Investment adjustments.

(a) Facts. M owns 80% of S's only class of stock with an $800 basis. For Year 1, S has $100 of taxable income.

(b) Analysis. Under paragraph (c)(1) of this section, the $100 positive adjustment under paragraph (b) of this section for S's taxable income is allocated among the shares of S's stock, including shares owned by nonmembers. Under paragraph (c)(2)(i) of this section, the adjustment is allocated equally to each share of S's stock. Thus, M increases its basis in S's stock under paragraph (b) of this section as of the close of Year 1 by $80. (The basis of the 20% of S's stock owned by nonmembers is not adjusted under this section.)

(c) Varying interest. The facts are the same as in paragraph (a) of this Example 1, except that M buys the remaining 20% of S's stock at the close of business on June 30 of Year 1 for $208. Under paragraph (b)(1) of this section and the principles of § 1.1502-76(b), S's $100 of taxable income is allocable $40 to the period from January 1 to June 30 and $60 to the period from July 1 to December 31. Thus, for the period ending June 30, M is treated as having a $32 adjustment with respect to the S stock that M has owned since January 1 (80% of $40) and, under paragraph (c)(2)(i) of this section, the adjustment is allocated equally among those shares. For the period ending December 31, M is treated as having a $60 adjustment (100% of $60) that is also allocated equally among M's shares of S's stock owned after June 30. M's basis in the shares owned as of the beginning of the year therefore increases by $80 (the sum of 80% of $40 and 80% of $60), from $800 to $880, and M's basis in the shares purchased on June 30 increases by $12 (20% of $60), from $208 to $220. Thus, M's aggregate basis in S's stock as of the end of Year 1 is $1,100.

(d) Tax liability. The facts are the same as in paragraph (a) of this Example 1, except that M pays S's $34 share of the group's consolidated tax liability resulting from S's taxable income, and S does not reimburse M. S's $100 of taxable income results in a positive adjustment under paragraph (b)(3)(i) of this section, and S's $34 of tax liability results in a negative adjustment under paragraph (b)(3)(iv)(D) of this section and the principles of section 1552. Because S does not make any payment in recognition of the additional tax liability, by analogy to the treatment under § 1.1552-1(b)(2), S is treated as having made a $34 payment that is described in paragraph (b)(3)(iii) of this section (noncapital, nondeductible expenses) and as having received an equal amount from M as a capital contribution. Thus, M increases its basis in its S stock by $52.80 (80% of the $100 of taxable income, less 80% of the $34 tax payment). In addition, M increases its basis in S's stock by $34 under the Internal Revenue Code and paragraph (a)(2) of this section to reflect the capital contribution. In the aggregate, M increases its basis in S's stock by $86.80. (If, as in paragraph (c) of this Example 1, M buys the remaining 20% of S's stock at the close of business on June 30, M increases its basis in S's stock by another $7.90 for the additional 20% interest in S's income after June 30 ($60 multiplied by 20%, less 20% of the $20.40 tax payment on $60); the $34 capital contribution by M is reflected in all of its S shares (not just the original 80%), and M's aggregate basis adjustment under this section is $94.70 ($86.80 plus $7.90).)

(a) Facts. M owns all of S's common stock with an $800 basis, and nonmembers own all of S's preferred stock. The preferred stock was issued for $200, has a $20 annual, cumulative preference as to dividends, and has an initial liquidation preference of $200. For Year 1, S has $50 of taxable income and no distributions are declared or made.

(b) Analysis of arrearages. Under paragraphs (c) (1) and (3) of this section, $20 of the $50 positive adjustment under paragraph (b) of this section is allocated first to the preferred stock to reflect the dividend arrearage arising in Year 1. The remaining $30 of the positive adjustment is allocated to the common stock, increasing M's basis from $800 to $830 as of the close of Year 1. (The basis of the preferred stock owned by nonmembers is not adjusted under this section.)

(c) Current distribution. The facts are the same as in paragraph (a) of this Example 2, except that S declares and makes a $20 distribution with respect to the preferred stock during Year 1 in satisfaction of its preference. The results are the same as in paragraph (b) of this Example 2.

(d) Varying interest. The facts are the same as in paragraph (a) of this Example 2, except that S has no income or loss for Years 1 and 2, M purchases all of S's preferred stock at the beginning of Year 3 for $240, and S has $70 of taxable income for Year 3. Under paragraph (c)(3) of this section, $60 of the $70 positive adjustment under paragraph (b) of this section is allocated to the preferred stock to reflect the dividends arrearages for Years 1 through 3, but only the $20 for Year 3 is reflected in the basis of the preferred stock under paragraph (b) of this section. (The remaining $40 is not reflected because the preferred stock was owned by nonmembers during Years 1 and 2.) Thus, M increases its basis in S's preferred stock from $240 to $260, and its basis in S's common stock from $800 to $810, as of the close of Year 3. (If M had acquired all of S's preferred stock in a transaction to which section 351 applies, and M's initial basis in S's preferred stock was $200 under section 362, M's basis in S's preferred stock would increase from $200 to $220.)

(e) Varying interest with current distributions. The facts are the same as in paragraph (d) of this Example 2, except that S declares and makes a $20 distribution with respect to the preferred stock in each of Years 1 and 2 in satisfaction of its preference, and M purchases all of S's preferred stock at the beginning of Year 3 for $200. Under paragraph (c)(3) of this section, $40 of the $70 positive adjustment under paragraph (b) of this section is allocated to the preferred stock to reflect the distributions in Years 1 and 2, and $20 of the $70 is allocated to the preferred stock to reflect the arrearage for Year 3. However, as in paragraph (d) of this Example 2, only the $20 attributable to Year 3 is reflected in the basis of the preferred stock under paragraph (b) of this section. Thus, M increases its basis in S's preferred stock from $200 to $220, and M increases its basis in S's common stock from $800 to $810.

(a) Facts. M owns all of S's common and preferred stock. The preferred stock has a $100 annual, cumulative preference as to dividends. For Year 1, S has $200 of taxable income, the first $100 of which is allocated to the preferred stock and the remaining $100 of which is allocated to the common stock. For Year 2, S has no adjustment under paragraph (b) of this section, and M sells all of S's common stock at the close of Year 2.

(b) Analysis. Under paragraph (c)(4) of this section, M's basis in S's common stock must be redetermined as of the sale of the stock. The redetermination is made by reallocating the $200 positive adjustment under paragraph (b) of this section for Year 1 by taking into account all of the facts and circumstances affecting allocations as of the sale. Thus, the $200 positive adjustment for Year 1 is reallocated entirely to the preferred stock to reflect the dividend arrearages for Years 1 and 2. The reallocation away from the common stock reflects the fact that, because of the additional amount of arrearage in Year 2, the common stock is not entitled to any part of the $200 of taxable income from Year 1. Thus, the common stock has no positive or negative adjustment, and the preferred stock has a $200 positive adjustment. These reallocations are treated as the original allocations for Years 1 and 2. (The results for the common stock would be the same if the common and preferred stock were not owned by the same member, or the preferred stock were owned by nonmembers.)

(c) Preferred stock issued after adjustment arises. The facts are the same as in paragraph (a) of this Example 3, except that S does not issue its preferred stock until the beginning of Year 2, S has no further adjustment under paragraph (b) of this section for Years 2 and 3, and M sells S's common stock at the close of Year 3. Under paragraphs (c) (1) and (2) of this section, the $200 positive adjustment for Year 1 is initially allocated entirely to the common stock. Under paragraph (c)(4) of this section, the $200 adjustment is reallocated to the preferred stock to reflect the arrearages for Years 2 and 3. Thus, the common stock has no positive or negative adjustment.

(d) Common stock issued after adjustment arises. The facts are the same as in paragraph (a) of this Example 3, except that S has no preferred stock, S issues additional common stock of the same class at the beginning of Year 2, S has no further adjustment under paragraph (b) of this section in Years 2 and 3, and M sells its S common stock at the close of Year 3. Under paragraphs (c) (1) and (2) of this section, the $200 positive adjustment for Year 1 is initially allocated entirely to the original common stock. Under paragraph (c)(4)(i)(A) of this section, the $200 adjustment is not reallocated among the original common stock and the additional stock. Unlike the preferred stock in paragraph (c) of this Example 3, the additional common stock is of the same class as the original stock, and there is no reallocation between shares of the same class.

(e) Positive and negative adjustments. The facts are the same as in paragraph (a) of this Example 3, except that S has a $200 loss for Year 2 that results in a negative adjustment to the common stock before any redetermination. For purposes of the basis redetermination under paragraph (c)(4) of this section, the Year 1 and 2 adjustments under paragraph (b) of this section are not netted. Thus, as in paragraph (b) of this Example 3, the redetermination is made by reallocating the $200 positive adjustment for Year 1 entirely to the preferred stock. The $200 negative adjustment for Year 2 is allocated entirely to the common stock. Consequently, the preferred stock has a $200 positive cumulative adjustment, and the common stock has a $200 negative cumulative adjustment. (The results would be the same if there were no other adjustments described in paragraph (b) of this section, M sells S's common stock at the close of Year 3 rather than Year 2, and an additional $100 arrearage arises in Year 3; only adjustments under paragraph (b) of this section may be reallocated, and there is no additional adjustment for Year 3.)

(f) Current distributions. The facts are the same as in paragraph (a) of this Example 3, except that, during Year 1, S declares and makes a distribution to M of $100 as a dividend on the preferred stock and $100 as a dividend on the common stock. The taxable income and distributions result in no Year 1 adjustment under paragraph (b) of this section for either the common or preferred stock. For example, if T merges into S, S is treated, as the context may require, as a successor to T and as becoming a member of the group. However, as in paragraph (b) of this Example 3, the redetermination under paragraph (c)(4) of this section is made by reallocating a $200 positive adjustment for Year 1 (S's net adjustment described in paragraph (b) of this section, determined without taking distributions into account) to the preferred stock. Consequently, the preferred stock has a $100 positive cumulative adjustment ($200 of taxable income, less a $100 distribution with respect to the preferred stock) and the common stock has a $100 negative cumulative adjustment (for the distribution).

(g) Convertible preferred stock. The facts are the same as in paragraph (a) of this Example 3, except that the preferred stock is convertible into common stock that is identical to the common stock already outstanding, the holders of the preferred stock convert the stock at the close of Year 2, and no stock is sold until the close of Year 5. Under paragraph (c)(4) of this section, the $200 positive adjustment for Year 1 is reallocated entirely to the preferred stock immediately before the conversion. The newly issued common stock is treated as a second class of S common stock, and adjustments under paragraph (b) of this section are allocated between the original and the new common stock under paragraph (c)(2)(ii) of this section. Although the preferred stock is converted to common stock, the $200 adjustment to the preferred stock is not subsequently reallocated between the original and the new common stock. Because the original and the new stock are equivalent, adjustments under paragraph (b) of this section for subsequent periods are allocated equally to each share.

(h) Prior use of allocations. The facts are the same as in paragraph (a) of this Example 3, except that M sells 10% of S's common stock at the close of Year 1, and the remaining 90% at the close of Year 2. M's basis in the common stock sold in Year 1 reflects $10 of the adjustment allocated to the common stock for Year 1. Under paragraph (c)(4)(ii) of this section, because $10 of the Year 1 adjustment was used in determining M's gain or loss, only $90 is reallocated to the preferred stock, and $10 remains allocated to the common stock sold.

(i) Lower-tier members. The facts are the same as in paragraph (a) of this Example 3, except that M owns only S's common stock, and M is also a subsidiary. If there is a redetermination under paragraph (c)(4) of this section by a member owning M's stock, a redetermination with respect to S's stock must be made first, and the effect of that redetermination on M's adjustments is taken into account under paragraph (b) of this section. However, as in paragraph (h) of this Example 3, to the extent an amount of the initial adjustments with respect to S's common stock have already been tiered up and used by a member owning M's stock, that amount remains with S's common stock (and the higher-tier member using the adjustment with respect to M's stock), and may not be reallocated to S's preferred stock.

(a) Facts. M owns all of S's only class of stock, and S owns all of T's common and preferred stock. The preferred stock has a $100 annual, cumulative preference as to dividends. For Year 1, T has $200 of taxable income, the first $100 of which is allocated to the preferred stock and the remaining $100 of which is allocated to the common stock, and S has no adjustments other than the amounts tiered up from T. S and T have no adjustments under paragraph (b) of this section for Years 2 and 3. X, the common parent of another consolidated group, purchases all of S's stock at the close of Year 3, and S and T become members of the X group. For Year 4, T has $200 of taxable income, and S has no adjustments other than the amounts tiered up from T.

(b) Analysis for Years 1 through 3. Under paragraph (c)(4) of this section, the allocation of S's adjustments under paragraph (b) of this section (determined without taking distributions into account) must be redetermined as of the time M sells S's stock. As a result of this redetermination, T's common stock has no positive or negative adjustment and the preferred stock has a $200 positive adjustment.

(c) Analysis for Year 4. Under paragraph (c)(3) of this section, the allocation of T's $200 positive adjustment in Year 4 to T's preferred stock with respect to arrearages is made by taking into account the consolidated return years of both the M group and the X group. Thus, the allocation of the $200 positive adjustment for Year 4 to T's preferred stock is not treated as an allocation for a period for which the preferred stock is owned by a nonmember. Thus, the $200 adjustment is reflected in S's basis in T's preferred stock under paragraph (b) of this section.

(a) Facts. S has 100 shares of common stock and 100 shares of preferred stock described in section 1504(a)(4). M owns 80 shares of S's common stock and all of S's preferred stock. The shareholders expect that S will have negative adjustments under paragraph (b) of this section for Years 1 and 2 (all of which will be allocable to S's common stock), the negative adjustments will have no significant effect on the value of S's stock, and S will have offsetting positive adjustments thereafter. When the preferred stock was issued, M intended to cause S to recapitalize the preferred stock into additional common stock at the end of Year 2 in a transaction described in section 368(a)(1)(E). M's temporary ownership of the preferred stock is with a principal purpose to limit M's basis reductions under paragraph (b) of this section to 80% of the anticipated negative adjustments. The recapitalization is intended to cause significantly more than 80% of the anticipated positive adjustments to increase M's basis in S's stock because of M's increased ownership of S's common stock immediately after the recapitalization.

(b) Analysis. S has established a transitory capital structure with a principal purpose to enhance M's basis in S's stock under this section. Under paragraph (e)(1) of this section, all of S's common and preferred stock is treated as a single class of common stock in Years 1 and 2 for purposes of this section. Thus, S's items are allocated under the principles of paragraph (c)(2)(ii) of this section, and M decreases its basis in both the common and preferred stock accordingly.

(a) Facts. M owns all of the stock of S and T, and S and T each own 50% of the stock of U. M's S stock has a $150 basis and $200 value, and M's T stock has a $200 basis and $200 value. With a principal purpose to eliminate M's gain from an anticipated sale of S's stock, T contributes to U an asset with a $100 value and $0 basis, and S contributes $100 cash. U sells T's asset and recognizes a $100 gain that results in a $100 positive adjustment under paragraph (b) of this section.

(b) Analysis. Under paragraph (c)(2) of this section, U's adjustment ordinarily would be allocated equally to each share of U's stock. If so allocated, M's basis in S's stock would increase from $150 to $200 and M would recognize no gain from the sale of S's stock for $200. Under paragraph (e)(1) of this section, however, because T transferred an appreciated asset to U with a principal purpose to shift a portion of the stock basis increase from M's stock in T to M's stock in S, the allocation of the $100 positive adjustment under paragraph (c) of this section between the shares of U's stock must take into account the contribution. Consequently, all $100 of the positive adjustment is allocated to the U stock owned by T, rather than $50 to the U stock owned by S and $50 to the U stock owned by T. M's basis in S's stock remains $150, and its basis in T's stock increases to $300. Thus, M recognizes a $50 gain from its sale of S's stock for $200.

(a) Facts. M forms S with an $800 contribution, $200 of which is in exchange for S's preferred stock described in section 1504(a)(4) and the balance of which is for S's common stock. For Years 1 through 3, S has a total of $160 of ordinary income, $60 of which is distributed with respect to the preferred stock in satisfaction of its $20 annual preference as to dividends. Under this section, M's basis in S's preferred stock is unchanged, and its basis in S's common stock is increased from $600 to $700. To reduce its gain from an anticipated sale of S's preferred stock, M forms T at the close of Year 3 with a contribution of all of S's stock in exchange for corresponding common and preferred stock of T in a transaction to which section 351 applies. At the time of the contribution, the fair market value of the common stock is $700 and the fair market value of the preferred stock is $300 (due to a decrease in prevailing market interest rates). M subsequently sells T's preferred stock for $300.

(b) Analysis. Under section 358(b), M ordinarily has a $630 basis in T's common stock (70% of the $900 aggregate stock basis) and a $270 basis in T's preferred stock (30% of the $900 aggregate stock basis). However, because M transferred S's stock to T with a principal purpose to shift the allocation of basis adjustments under this section, adjustments are made under paragraph (e)(1) of this section to preserve the allocation under this section. Thus, M has a $700 basis in T's common stock and a $200 basis in T's preferred stock. Consequently, M recognizes a $100 gain from the sale of T's preferred stock.

(a) Facts. For Year 1, the M group has $40 of taxable income when determined by including only S's items of income, gain, deduction, and loss taken into account, and M increases its basis in S's stock by $40 under paragraph (b) of this section. M anticipates that S will have a $40 ordinary loss for Year 2 that will be carried back and offset S's income in Year 1 and result in a $40 reduction to M's basis in S's stock for Year 2 under paragraph (b) of this section. With a principal purpose to avoid the reduction, M causes S to issue voting preferred stock that results in S becoming a nonmember at the beginning of Year 2. As anticipated, S has a $40 loss for Year 2, which is carried back to Year 1 and offsets S's income from Year 1.

(b) Analysis. Under paragraph (e)(1) of this section, because M caused S to become a nonmember with a principal purpose to absorb S's loss but avoid the corresponding negative adjustment under this section, and M bears a substantial portion of the loss because of its continued ownership of S common stock, the basis of M's common stock in S is decreased by $40 for Year 2. (If M has less than a $40 basis in the retained S stock, M must recognize income for Year 2 to the extent of the excess.) Section 1504(a)(3) limits the ability of S to subsequently rejoin the M group's consolidated return.

(c) Carryback to pre-consolidation year. The facts are the same as in paragraph (a) of this Example 4, except that M anticipates that S's loss will be carried back and absorbed in a separate return year of S before Year 1 (rather than to the M group's consolidated return for Year 1). Although M causes S to become a nonmember with a principal purpose to avoid the negative adjustment under this section, and M bears a substantial portion of the loss because of its continued ownership of S common stock, both S's income and loss are taken into account under the separate return rules. Consequently, no one has acted with a principal purpose contrary to the purposes of this section, and no adjustments are necessary to carry out the purposes of this section.

(a) Facts. M forms S with a $100 contribution, and S becomes a member of the M affiliated group which does not file consolidated returns. For Years 1 through 3, S earns $300. M anticipates that it will elect under section 1501 for the M group to begin filing consolidated returns in Year 5. In anticipation of filing consolidated returns, and to avoid the negative stock basis adjustment that would result under paragraph (b) of this section from distributing S's earnings after Year 5, M causes S to distribute $300 during Year 4 as a qualifying dividend within the meaning of section 243(b). There is no plan or intention to recontribute the funds to S after the distribution.

(b) Analysis. Although S's distribution of $300 is with a principal purpose to avoid a corresponding negative adjustment under this section, the $300 was both earned and distributed entirely under the separate return rules. Consequently, M and S have not acted with a principal purpose contrary to the purposes of this section, and no adjustments are necessary to carry out the purposes of this section.