Corporate Tax | Just Tax

Built-in Loss Limitation on Contribution (§ 362(e)(2))

This checklist guides the analysis of whether a contribution of property to a corporation in a § 351 exchange or capital contribution triggers the built-in loss limitation of § 362(e)(2), and whether to make the § 362(e)(2)(C) election. Use this checklist whenever a transferor contributes property with an aggregate adjusted basis that exceeds the property's aggregate fair market value to a corporation in a transaction described in § 362(a).

Step 1. Transactions Within the Scope of § 362(e)(2)

"If (i) property is transferred by a transferor in any transaction which is described in subsection (a) and which is not described in paragraph (1) of this subsection, and (ii) the transferee's aggregate adjusted bases of such property so transferred would (but for this paragraph) exceed the fair market value of such property immediately after such transaction, then, notwithstanding subsection (a), the transferee's aggregate adjusted bases of the property so transferred shall not exceed the fair market value of such property immediately after such transaction." (§ 362(e)(2)(A))

• The three transaction types that trigger § 362(e)(2).
  • § 351 exchanges. A transfer of property to a corporation controlled by the transferor in exchange for stock. (§ 362(a)(1))
  • Capital contributions. A transfer of property to a corporation as paid-in surplus or as a contribution to capital, even if no stock is issued. (§ 362(a)(2))
  • Transactions described in both § 351 and another provision. A transaction is a "section 362(a) transaction" if it is described in § 362(a) without regard to whether it is also described in any other provision of the Code, including without limitation § 362(b) (reorganizations). (Treas. Reg. § 1.362-4(g)(2)(i))
  • EXAMPLE. A transfer of assets to a corporation that qualifies as both a § 351 exchange and a reorganization under § 368(a)(1)(D) is still subject to § 362(e)(2) because it is described in § 362(a). (Treas. Reg. § 1.362-4(h), Example 2)
• Transactions NOT subject to § 362(e)(2).
  • Reorganizations described only in § 362(b) without also being described in § 362(a). Pure reorganizations that do not also constitute § 351 exchanges, capital contributions, or paid-in surplus are not subject to § 362(e)(2). (§ 362(e)(2)(A)(i)) (Treas. Reg. § 1.362-4(g)(2)(i))
  • § 362(e)(1) loss importation transactions. If the transaction is described in § 362(e)(1), that provision applies instead and § 362(e)(2) does not apply. (§ 362(e)(2)(A)(i)) (Treas. Reg. § 1.362-4(b))
  • Intercompany transactions within a consolidated group. § 362(e)(2) does not apply to intercompany transactions occurring on or after September 17, 2008. (Treas. Reg. § 1.1502-80(h)(1)) See Step 11 for detailed analysis.
• Effective date of § 362(e)(2).
  • Enacted October 22, 2004, as part of the American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 836, 118 Stat. 1418. (H.R. Conf. Rep. No. 108-755, at 386-87 (2004))
  • Applies to transactions after October 22, 2004.
  • Treasury Regulations § 1.362-4 applies to transactions occurring after September 3, 2013, unless effected pursuant to a binding agreement that was in effect prior to September 3, 2013, and at all times thereafter. (Treas. Reg. § 1.362-4(j))
  • Taxpayers may apply the regulations to transactions occurring after October 22, 2004. (Treas. Reg. § 1.362-4(j))
  • TRAP. If your transaction occurred between October 22, 2004 and September 3, 2013, the regulations may apply only if the taxpayer elected to apply them. Pre-regulation transactions were governed by Notice 2005-70 (now obsolete) and the statute itself.

Step 2. The § 362(e)(1) Exclusion - Loss Importation Takes Priority

"If in any transaction described in subsection (a) or (b) there would (but for this subsection) be an importation of a net built-in loss, the basis of each property described in subparagraph (B) which is acquired in such transaction shall (notwithstanding subsections (a) and (b)) be its fair market value immediately after such transaction." (§ 362(e)(1)(A))

• The mutual exclusivity principle.
  • § 362(e)(2) applies only to transactions "not described in paragraph (1)" of § 362(e). (§ 362(e)(2)(A)(i))
  • If a transaction includes both importation property and non-importation property, § 362(e)(1) applies first to the importation property, and § 362(e)(2) then applies separately to the non-importation property transferred by each transferor. (Treas. Reg. § 1.362-4(h), Example 11)
• The two-prong test for importation property.
  • Property is described in § 362(e)(1)(B) only if BOTH of the following conditions are met.
  • Prong One. Gain or loss with respect to such property is NOT subject to tax under subtitle A in the hands of the transferor immediately before the transfer. (§ 362(e)(1)(B)(i))
  • Prong Two. Gain or loss with respect to such property IS subject to tax under subtitle A in the hands of the transferee immediately after the transfer. (§ 362(e)(1)(B)(ii))
  • EXAMPLE. Property owned by a foreign corporation that is not subject to U.S. tax in the foreign corporation's hands, but that would be subject to U.S. tax when held by a U.S. corporation, is importation property. (§ 362(e)(1)(B))
• The importation of net built-in loss threshold.
  • There is an importation of a net built-in loss if the transferee's aggregate adjusted bases of property described in § 362(e)(1)(B) would (but for § 362(e)(1)) exceed the fair market value of such property immediately after the transaction. (§ 362(e)(1)(C))
  • When the transferor is a partnership, the analysis is applied by treating each partner as holding its proportionate share of partnership property. (§ 362(e)(1)(B))
• Critical differences between § 362(e)(1) and § 362(e)(2).
  • § 362(e)(1) applies to both § 362(a) and § 362(b) transactions. § 362(e)(2) applies only to § 362(a) transactions. (§ 362(e)(1)(A)) (§ 362(e)(2)(A)(i))
  • § 362(e)(1) applies on an aggregate basis across all transferors. § 362(e)(2) applies separately to each transferor. (Treas. Reg. § 1.362-4(b))
  • § 362(e)(1) gives FMV basis to EACH importation property. § 362(e)(2) reduces basis only to loss duplication property, by each property's allocable portion. (§ 362(e)(1)(A)) (§ 362(e)(2)(B))
  • No election is available under § 362(e)(1). The § 362(e)(2)(C) election is available only for § 362(e)(2) transactions. (§ 362(e)(2)(C))

Step 3. The Loss Duplication Transaction Test

"A loss duplication transaction is a section 362(a) transaction in which Acquiring's aggregate basis in the property received from Transferor would, but for section 362(e)(2) and this section, exceed the aggregate value of such property immediately after the transaction." (Treas. Reg. § 1.362-4(g)(2))

• The two-part test applied separately to each transferor.
  • First, determine whether the transaction is described in § 362(a) (see Step 1). If yes, proceed to the second part.
  • Second, determine whether the transferee corporation's aggregate adjusted basis in all property received from a single transferor would (but for § 362(e)(2)) exceed the aggregate fair market value of that property immediately after the transaction. (Treas. Reg. § 1.362-4(g)(2)(ii))
  • The analysis is performed SEPARATELY for each transferor. If multiple transferors contribute property in the same transaction, one transferor may trigger § 362(e)(2) while another does not. (Treas. Reg. § 1.362-4(b))
• Computing aggregate basis for the test.
  • Acquiring's aggregate basis is determined immediately after the transaction and without regard to § 362(e)(2), but otherwise taking into account all applicable provisions of law, including without limitation § 362(e)(1). (Treas. Reg. § 1.362-4(g)(2)(ii))
  • This means the starting point is the carryover basis rule of § 362(a), adjusted for any gain recognized by the transferor and any applicable basis adjustments.
  • If the transferor recognizes gain under § 351(b) on boot received, that gain increases Acquiring's basis in the contributed property. (§ 362(a))
  • If § 362(e)(1) applies to any property in the transaction, the FMV basis assigned under § 362(e)(1) is included in the aggregate basis computation for purposes of determining whether § 362(e)(2) applies to the remaining property. (Treas. Reg. § 1.362-4(h), Example 11)
• Computing aggregate value for the test.
  • The aggregate value is the fair market value of all property received from the transferor immediately after the transaction. (Treas. Reg. § 1.362-4(g)(2)(ii))
  • For most property, value is determined under general fair market value principles assuming an exchange between a willing buyer and a willing seller. (Treas. Reg. § 1.362-4(g)(12)(i))
  • For partnership interests, a special value rule applies. See Step 9.
• The threshold question.
  • If aggregate basis > aggregate value → loss duplication transaction exists → proceed to Steps 4 and 5.
  • If aggregate basis ≤ aggregate value → no loss duplication transaction → § 362(e)(2) does not apply to that transferor's property.
  • EXAMPLE. Transferor contributes Asset 1 (basis $90, FMV $90) and Asset 2 (basis $110, FMV $120). Aggregate basis is $200. Aggregate value is $210. No loss duplication transaction exists because aggregate basis does not exceed aggregate value. (Treas. Reg. § 1.362-4(h), Example 1)
  • EXAMPLE. Transferor contributes Asset 1 (basis $90, FMV $90) and Asset 2 (basis $110, FMV $80). Aggregate basis is $200. Aggregate value is $170. Loss duplication transaction exists because aggregate basis exceeds aggregate value by $30. (Treas. Reg. § 1.362-4(h), Example 1)

Step 4. Identifying Loss Duplication Property

"Loss duplication property is any property (i) that is transferred by Transferor to Acquiring in a loss duplication transaction, and (ii) that Acquiring would take with a basis in excess of value immediately after the transaction." (Treas. Reg. § 1.362-4(g)(1))

• The asset-by-asset test.
  • Even when a loss duplication transaction exists, § 362(e)(2) does not affect every asset transferred. It affects only those individual assets that satisfy the definition of "loss duplication property."
  • For each asset transferred, determine whether Acquiring would take the asset with a basis in excess of its value immediately after the transaction, determined without regard to § 362(e)(2) but taking into account all other applicable provisions of law including § 362(e)(1). (Treas. Reg. § 1.362-4(g)(1)(ii))
  • If an asset's basis would equal or be less than its value, that asset is NOT loss duplication property, and its basis is unaffected by § 362(e)(2).
• Assets with built-in gain are protected.
  • Property that has appreciated in value (basis less than or equal to FMV) is not loss duplication property, even when contributed as part of a loss duplication transaction that includes other loss assets. (Treas. Reg. § 1.362-4(h), Example 1)
  • The basis reduction under § 362(e)(2) applies ONLY to assets with built-in losses.
  • EXAMPLE. Transferor contributes Asset 1 (basis $90, FMV $90) and Asset 2 (basis $110, FMV $80) in a loss duplication transaction with $30 net built-in loss. Asset 1 is NOT loss duplication property because its $90 basis does not exceed its $90 value. Only Asset 2 is loss duplication property because its $110 basis exceeds its $80 value. (Treas. Reg. § 1.362-4(h), Example 1)
• The built-in loss computation for each asset.
  • A property's built-in loss is the excess of Acquiring's basis in the property (determined without regard to § 362(e)(2)) over the property's value immediately after the transaction. (Treas. Reg. § 1.362-4(g)(4))
  • This is the numerator for the allocation formula in Step 5.
• Special case. Gain recognition on some assets.
  • If the transferor recognizes gain on certain assets (for example, due to boot received under § 351(b)), that gain increases Acquiring's basis in those specific assets. An asset on which gain is recognized may have its basis increased above its value, converting it from a potential gain asset into loss duplication property. (Treas. Reg. § 1.362-4(h), Example 6)
  • EXAMPLE. Transferor contributes Asset 1 (basis $80, FMV $100) and Asset 2 (basis $30, FMV $25), and receives stock plus $25 cash. Transferor recognizes $20 gain on Asset 1 under § 351(b). Acquiring's basis in Asset 1 becomes $100 ($80 + $20 gain), which equals its value, so Asset 1 is not loss duplication property. Acquiring's basis in Asset 2 is $30, which exceeds its $25 value, so Asset 2 IS loss duplication property with a $5 built-in loss. (Treas. Reg. § 1.362-4(h), Example 6)

Step 5. Computing Net Built-in Loss and Allocating the Reduction

• Computing transferor's net built-in loss.
  • Transferor's net built-in loss is the excess of (i) Acquiring's aggregate basis in all property received from Transferor in the loss duplication transaction, over (ii) the aggregate value of such property immediately after the transaction. (Treas. Reg. § 1.362-4(g)(3))
  • This is the TOTAL amount by which Acquiring's aggregate basis in all transferred property exceeds the aggregate value.
  • The net built-in loss equals the total basis reduction that must be made under § 362(e)(2)(A).
  • EXAMPLE. Transferor contributes Asset 1 (basis $120, FMV $70) and Asset 2 (basis $100, FMV $110). Aggregate basis is $220. Aggregate value is $180. Net built-in loss is $40. (Treas. Reg. § 1.362-4(h), Example 4)
• Allocating the basis reduction among loss duplication property.
  • The aggregate reduction in basis is allocated among the loss duplication properties "in proportion to their respective built-in losses immediately before the transaction." (§ 362(e)(2)(B))
  • For each loss duplication property, the allocable portion equals the property's built-in loss divided by the aggregate built-in losses of all loss duplication property, multiplied by the transferor's net built-in loss. (Treas. Reg. § 1.362-4(g)(5))
  • Acquiring's final basis in each loss duplication property equals its basis determined without regard to § 362(e)(2), reduced by the property's allocable portion of the net built-in loss.
• The allocation formula illustrated.
  • EXAMPLE. Transferor contributes Asset 1 (basis $200, FMV $100) and Asset 2 (basis $90, FMV $90) in a § 351 exchange. Aggregate basis is $290. Aggregate value is $190. Net built-in loss is $100.
  • Asset 1 is loss duplication property (built-in loss of $100). Asset 2 is NOT loss duplication property (basis equals value, no built-in loss).
  • Allocation. The entire $100 net built-in loss is allocated to Asset 1 because it is the only loss duplication property. Acquiring's basis in Asset 1 is $100 ($200 - $100). Acquiring's basis in Asset 2 remains $90. (Adapted from Steptoe & Johnson LLP, "Limitation on Loss Duplication and Importation of Built-in Losses")
  • EXAMPLE. Transferor contributes Asset 1 (basis $120, FMV $70, built-in loss $50) and Asset 2 (basis $160, FMV $110, built-in loss $50) in a loss duplication transaction. Aggregate basis is $280. Aggregate value is $180. Net built-in loss is $100.
  • Both assets are loss duplication property. Aggregate built-in losses equal $100 ($50 + $50).
  • Asset 1's allocable portion = $100 × ($50/$100) = $50. Acquiring's basis in Asset 1 = $120 - $50 = $70.
  • Asset 2's allocable portion = $100 × ($50/$100) = $50. Acquiring's basis in Asset 2 = $160 - $50 = $110. (Treas. Reg. § 1.362-4(h), Example 4)
• Effect on transferor's stock basis under the default rule.
  • Under the default rule (no § 362(e)(2)(C) election), the transferor takes a carryover basis in the stock received under § 358(a), unreduced by § 362(e)(2).
  • The transferor's stock basis reflects the full carryover basis from the contributed property, preserving the built-in loss at the stock level. (§ 358(a)) (Treas. Reg. § 1.362-4(h), Example 1)
  • This creates the duplication that § 362(e)(2) prevents. The loss is preserved in the transferor's stock basis AND would have been preserved in the corporation's asset basis absent § 362(e)(2).
• CAUTION. Liabilities generally do not affect the § 362(e)(2) computation.
  • Liabilities assumed by the transferee corporation in the exchange do not affect the application of § 362(e)(2). The comparison is between the aggregate adjusted basis of the property transferred and the aggregate fair market value of that property. (Treas. Reg. § 1.362-4(h), Example 5)
  • However, liabilities DO affect the transferor's stock basis under § 358(d) (treated as money received) and may affect the value of a contributed partnership interest under the special rule in Treas. Reg. § 1.362-4(g)(12)(ii). See Step 9.

Step 6. The § 362(e)(2)(C) Election

"If the transferor and transferee of a transaction described in subparagraph (A) both elect the application of this subparagraph (I) subparagraph (A) shall not apply, and (II) the transferor's basis in the stock received for property to which subparagraph (A) does not apply by reason of the election shall not exceed its fair market value immediately after the transfer." (§ 362(e)(2)(C)(i))

• The fundamental choice.
  • The default rule of § 362(e)(2)(A) reduces the corporation's basis in the contributed loss assets to eliminate the built-in loss at the entity level.
  • The election under § 362(e)(2)(C) shifts the basis reduction from the corporation's assets to the transferor's stock basis, preserving the higher basis in the assets but limiting the transferor's stock basis to the property's FMV.
  • Both the transferor AND the transferee corporation must elect. A unilateral election is ineffective. (§ 362(e)(2)(C)(i))

Step 6A. Effect of Making the Election

• Acquiring's asset basis is preserved.
  • When the election is in effect, Acquiring's basis in loss duplication property is NOT determined under § 362(e)(2). (Treas. Reg. § 1.362-4(d)(2)(ii))
  • Acquiring takes a full carryover basis in the contributed property (subject to any other applicable adjustments such as gain recognized by the transferor).
  • The built-in loss is preserved in the assets and can be recognized by Acquiring on a subsequent sale of the assets or through depreciation/amortization deductions.
• Transferor's stock basis is reduced.
  • An amount equal to the net built-in loss that would otherwise have reduced asset basis is allocated among the shares received (or deemed received) in the exchange in proportion to the value of such shares. (Treas. Reg. § 1.362-4(d)(2)(i))
  • The reduction is applied to the transferor's basis as determined without regard to § 362(e)(2) (that is, the exchanged basis computed under § 358(a)).
  • The transferor's stock basis after the election cannot exceed the fair market value of the stock immediately after the transfer. (§ 362(e)(2)(C)(i)(II))
  • EXAMPLE. Transferor contributes Asset 2 (basis $30, FMV $25) along with Asset 1 on which $20 gain is recognized. Transferor's basis in stock received under § 358 is $105 ($80 basis in Asset 1 + $30 basis in Asset 2 + $20 gain recognized - $25 boot received). Net built-in loss is $5. With a § 362(e)(2)(C) election, transferor's stock basis is reduced by $5 to $100. Acquiring's basis in Asset 2 remains $30. (Treas. Reg. § 1.362-4(h), Example 6)
• Basis tracing rules do not apply.
  • When a § 362(e)(2)(C) election is made, the basis tracing provisions of § 1.358-2(a)(2) do not apply. The basis reduction is spread pro rata across all shares received based on their relative values, not traced to specific shares surrendered. (Preamble to T.D. 9633, 78 Fed. Reg. 54971, 54978 (Sept. 9, 2013))

Step 6B. Requirements for a Valid Election

• Step One. Written binding agreement.
  • Prior to filing the § 362(e)(2)(C) Statement, Transferor and Acquiring must enter into a written, binding agreement to elect to apply § 362(e)(2)(C). (Treas. Reg. § 1.362-4(d)(1)(i))
  • The regulation does not prescribe a particular form for the agreement. It can be a standalone document or incorporated into the contribution agreement, merger agreement, or other transaction documentation. (Preamble to T.D. 9633, 78 Fed. Reg. at 54978)
  • Both parties must be legally bound before the statement is filed. An agreement signed after the statement is filed does not validate the election.
  • The agreement must be in writing. An oral agreement is insufficient.
• Step Two. The § 362(e)(2)(C) Statement.
  • The statement must be titled "§ 362(e)(2)(C) Statement." (Treas. Reg. § 1.362-4(d)(3)(i))
  • The statement must identify Transferor and Acquiring by name and tax identification number. (Treas. Reg. § 1.362-4(d)(3)(i)(A))
  • The statement must state that Transferor and Acquiring have entered into a written, binding agreement to elect to apply § 362(e)(2)(C). (Treas. Reg. § 1.362-4(d)(3)(i)(B))
  • The statement must state the date of the transaction (or all dates if transfers occurred on multiple dates). (Treas. Reg. § 1.362-4(d)(3)(i)(C))
• Step Three. Filing the statement.
  • The statement must be filed on or with the timely filed (including extensions) original U.S. return for the taxable year in which the transfer occurred. (Treas. Reg. § 1.362-4(d)(3)(ii)(A))
  • It must be filed on the ORIGINAL return, not an amended return. (Treas. Reg. § 1.362-4(d)(3)(ii))
  • The entity (not individual partners or shareholders) files if Transferor is a partnership, S corporation, trust, or other pass-through entity, or if Acquiring is an S corporation. (Treas. Reg. § 1.362-4(d)(3)(ii))
  • For CFC transferors not required to file a U.S. return, all controlling U.S. shareholders must file the statement with their timely filed original returns. (Treas. Reg. § 1.362-4(d)(3)(ii)(B))
  • For CFP transferors not required to file a U.S. return, all reporting U.S. partners must file the statement with their timely filed original returns. (Treas. Reg. § 1.362-4(d)(3)(ii)(B))
  • If neither Transferor nor Acquiring is a U.S. filer but Acquiring is required to file a U.S. return, Acquiring files the statement. (Treas. Reg. § 1.362-4(d)(3)(ii)(C))
  • CAUTION. The seven-tier filing hierarchy in Treas. Reg. § 1.362-4(d)(3)(ii)(A) through (G) must be followed exactly. The wrong party filing the statement can invalidate the election. See Step 12 for the complete hierarchy.
• The election is irrevocable.
  • "Once made, shall be irrevocable." (§ 362(e)(2)(C)(ii))
  • A protective election can be made when the parties are uncertain whether § 362(e)(2) applies. The protective election has no effect if the transaction is ultimately determined not to be subject to § 362(e)(2), but is binding and irrevocable if § 362(e)(2) does apply. (Treas. Reg. § 1.362-4(d)(1))
  • TRAP. Because the election is irrevocable, practitioners should model both scenarios thoroughly before the transaction closes. Once the binding agreement is signed and the statement is filed, the decision cannot be undone even if tax consequences turn out to be unfavorable.

Step 6C. Strategic Considerations for the Election

• When to consider the election.
  • The election is advantageous when the transferee corporation is more likely to realize the economic benefit of the higher asset basis (through depreciation, amortization, or eventual sale of assets at a loss).
  • The election is disadvantageous when the transferor is more likely to benefit from the loss (through a planned sale of the stock at a loss).
  • The election may be beneficial when the transferor is unlikely to sell the stock (for example, in a permanent holding company structure).
  • State tax considerations may favor the election in separate-return states where preserving the transferee's asset basis reduces the transferee's separate state taxable income.
• When to accept the default asset basis reduction.
  • The default is preferable when the transferor plans to sell the stock and the carryover basis preserves a valuable loss deduction.
  • The default is preferable when the transferee will quickly sell the assets, making the higher carryover basis less valuable.
  • The default is preferable when the built-in loss is small relative to the overall transaction.
• CAUTION. S corporation considerations.
  • When an S corporation is the Transferor and the election is made, the stock basis reduction is treated as an expense described in § 1367(a)(2)(D), which passes through to reduce each shareholder's stock basis. (Treas. Reg. § 1.362-4(e)(2)) See Step 9.
  • When an S corporation is the Acquiring corporation and no election is made, the asset basis reduction is NOT treated as a § 1367(a)(2)(D) expense. Shareholders preserve their full stock basis. (Treas. Reg. § 1.362-4(f))

Step 7. Exceptions to § 362(e)(2) Application

Step 7A. Complete Distribution Exception

• When the exception applies.
  • § 362(e)(2) does not apply to a transaction to the extent that (i) without recognizing gain or loss, the Transferor distributes the Acquiring stock received in the transaction, and (ii) upon completion of the transaction, no person holds Acquiring stock or any other asset with a basis determined in whole or in part by reference to the Transferor's basis in the distributed Acquiring stock. (Treas. Reg. § 1.362-4(c)(1))
  • The rationale is that when the stock is fully distributed and no person retains an asset with a substituted basis from the Transferor's stock, there is no duplicated loss to prevent. (Preamble to T.D. 9633, 78 Fed. Reg. at 54976)
• When the exception does not apply.
  • If the Transferor retains ANY Acquiring stock or securities after the distribution, § 362(e)(2) applies to the retained portion. (Treas. Reg. § 1.362-4(h), Example 4(iii))
  • If § 355(e) applies to the distribution (triggering gain recognition), the exception does not apply because the distribution is not "without recognizing gain or loss." (Treas. Reg. § 1.362-4(h), Example 4(ii))
  • If any person holds an asset with a basis determined by reference to the Transferor's basis in the distributed stock (for example, through a subsequent transferred basis transaction), the exception fails.
  • EXAMPLE. X transfers assets to Y in exchange for Y stock, then distributes all Y stock to A in exchange for all of A's X stock under § 355. X recognizes no gain or loss under § 361(c)(1). No person holds Y stock with basis determined by reference to X's basis. The exception applies and § 362(e)(2) does not apply. Y takes full carryover basis in the assets. (Treas. Reg. § 1.362-4(h), Example 4(i))
  • EXAMPLE. Same facts, but § 355(e) applies, so X recognizes gain under § 361(c)(2). The exception does not apply. § 362(e)(2) applies in full. (Treas. Reg. § 1.362-4(h), Example 4(ii))

Step 7B. Foreign Transaction Exception

• The two-year safe harbor for wholly foreign transactions.
  • § 362(e)(2) does not apply to a transaction if three conditions are met. (Treas. Reg. § 1.362-4(c)(2))
  • Condition One. Neither Transferor nor Acquiring is a U.S. person (as defined in § 7701(a)(30)), a person otherwise required to file a U.S. return, a controlled foreign corporation (CFC), or a controlled foreign partnership (CFP) on the date of the transaction. (Treas. Reg. § 1.362-4(c)(2)(i))
  • Condition Two. The transfer occurs more than two years prior to the date of any event described in Treas. Reg. § 1.362-4(d)(3)(ii)(E), (F), or (G). (Treas. Reg. § 1.362-4(c)(2)(ii))
  • Condition Three. The original transaction and the subsequent triggering events were not entered into with a view to reducing or avoiding the Federal income tax liability of any person by avoiding the application of § 362(e)(2). (Treas. Reg. § 1.362-4(c)(2)(iii))
• Triggering events that cause the exception to be lost.
  • Event (E). Transferor later becomes a U.S. person, CFC, or CFP (or a person required to file a U.S. return). (Treas. Reg. § 1.362-4(d)(3)(ii)(E))
  • Event (F). Acquiring later becomes a U.S. person, CFC, or CFP (or a person required to file a U.S. return). (Treas. Reg. § 1.362-4(d)(3)(ii)(F))
  • Event (G). The basis of loss duplication property or Acquiring stock later becomes relevant for Federal income tax purposes. (Treas. Reg. § 1.362-4(d)(3)(ii)(G))
  • The two-year clock starts on the date of the transaction and runs until the date of the triggering event. If any triggering event occurs within two years, the exception is lost and § 362(e)(2) applies retroactively.
  • EXAMPLE. FC1 transfers loss property to FC2 in a § 351 transaction. More than two years later, FC2 transfers the property to FC3 in a transferred basis transaction. In Year 2, FC3 becomes engaged in a U.S. trade of business and must file a U.S. return. FC3's U.S. entry is an event under (d)(3)(ii)(F). If the transfer to FC2 occurred more than two years before FC3's U.S. entry, the exception applies. If within two years, the exception is lost. (Treas. Reg. § 1.362-4(h), Example 12(v))
• Key definitions for the foreign exception.
  • A CFC is any corporation described in § 957 or § 953(c). (Treas. Reg. § 1.362-4(g)(7))
  • A CFP is any partnership treated as a controlled foreign partnership for purposes of § 6038. (Treas. Reg. § 1.362-4(g)(9))
  • A controlling U.S. shareholder is any person treated as a controlling U.S. shareholder under § 1.964-1(c)(5). (Treas. Reg. § 1.362-4(g)(8))
  • A reporting U.S. partner is any partner of a CFP that is required to file an information return with respect to the CFP pursuant to § 6038. (Treas. Reg. § 1.362-4(g)(10))

Step 8. Consolidated Return Intercompany Transactions

• The general rule. § 362(e)(2) does not apply.
  • § 362(e)(2) does not apply to any intercompany transaction occurring on or after September 17, 2008. (Treas. Reg. § 1.1502-80(h)(1))
  • Taxpayers may apply this rule to intercompany transactions occurring on or after October 22, 2004, and in such case, any election made under § 362(e)(2)(C) will have no effect. (Treas. Reg. § 1.1502-80(h)(1))
  • The purpose is to allow the consolidated return provisions (particularly the investment adjustment rules of § 1.1502-32 and the unified loss rule of § 1.1502-36) to address loss duplication within the consolidated group. (Preamble to T.D. 9424, 73 Fed. Reg. 53,934, 53,945 (Sept. 17, 2008))
• The anti-abuse rule.
  • If a taxpayer engages in a transaction to which § 362(e)(2) would apply but for § 1.1502-80(h)(1), and acts with a view to prevent the consolidated return provisions from properly addressing loss duplication, appropriate adjustments will be made to clearly reflect the income of the group. (Treas. Reg. § 1.1502-80(h)(2)(i))
  • EXAMPLE (abusive). P, the common parent of a consolidated group, owns four shares of S stock with aggregate basis of $0 and value of $80. S owns Asset 1 with basis of $0 and value of $80. With a view to prevent the consolidated return provisions from addressing loss duplication, P transfers Asset 2 with basis of $100 and value of $20 to S in exchange for a new share of S stock (Share 5) in a § 351 transaction. P later sells only Share 5 to X for $20. Because S has no aggregate inside loss, the unified loss rule would not reduce S's attributes. The anti-abuse rule applies. Either P's basis in Share 5 or S's basis in Asset 2 must be adjusted to reflect what it would have been had § 362(e)(2) been applied at the time of transfer. (Treas. Reg. § 1.1502-80(h)(2)(ii), Example (A) and (B))
  • EXAMPLE (non-abusive). Same facts, but P sells ALL five shares of S stock to X. The $80 duplicated loss is offset by an $80 duplicated gain across the share blocks. The transaction does not prevent the consolidated return provisions from properly addressing loss duplication. The anti-abuse rule does not apply. (Treas. Reg. § 1.1502-80(h)(2)(ii), Example (C))
• How the consolidated provisions address loss duplication instead.
  • The investment adjustment rules of § 1.1502-32 adjust the parent's basis in subsidiary stock to reflect the subsidiary's income, losses, and distributions, preventing the duplication of economic gains and losses.
  • The unified loss rule of § 1.1502-36 applies a three-tier analysis (basis redetermination, basis reduction, and attribute reduction) when a member transfers loss shares of subsidiary stock, ensuring that noneconomic or duplicated losses are not recognized.
  • For pre-September 17, 2008 intercompany transactions that were subject to § 362(e)(2), § 1.1502-36(e)(2) provides adjustment rules to coordinate with prior § 362(e)(2) basis reductions or § 362(e)(2)(C) elections. (Treas. Reg. § 1.1502-36(e)(2)(i)-(ii))
• State tax implications for consolidated groups.
  • § 1.1502-80(h) applies only for federal consolidated return purposes. It does not control state tax treatment.
  • In states that require separate returns for each corporation, § 362(e)(2) applies to intercompany transfers even though the group files a federal consolidated return. (Treas. Reg. § 1.1502-80(h)(1))
  • Practitioners should consider making protective § 362(e)(2)(C) elections for state tax purposes even when the transaction is an intercompany transfer exempt from § 362(e)(2) at the federal level. (PLR 201414006 (Jan. 9, 2014))
  • TRAP. A protective federal election filed for state tax purposes has no effect on the federal consolidated return but may be necessary to preserve basis in separate-return states.

Step 9. Special Rules for Partnerships and S Corporations

Step 9A. Partnership Transferors

• The § 705(a)(2)(B) expenditure rule.
  • If a partnership transfers property in a loss duplication transaction with respect to which a § 362(e)(2)(C) election is made, the resulting reduction to the partnership's basis in the Acquiring stock is treated as an expenditure of the partnership described in § 705(a)(2)(B). (Treas. Reg. § 1.362-4(e)(1))
  • This means the stock basis reduction flows through to reduce each partner's outside basis in the partnership.
  • The expenditure is non-deductible and non-capital in nature.
• Partnership interest contributions and the special value rule.
  • When a partnership interest is contributed to a corporation, the value of the partnership interest for § 362(e)(2) purposes equals the sum of (i) the cash that Acquiring would receive if it immediately sold the interest, plus (ii) any § 1.752-1 liabilities of the partnership allocated to Acquiring under § 752 immediately after the transfer. (Treas. Reg. § 1.362-4(g)(12)(ii))
  • Acquiring's basis in the partnership interest equals the transferor's outside basis, reduced by the transferor's share of partnership liabilities (deemed distribution), and increased by Acquiring's share of partnership liabilities (deemed contribution). (§ 362(a)) (§ 752)
  • EXAMPLE. A has a $247 basis in his partnership interest and a $145 share of partnership liabilities. A transfers his interest to X. X's share of partnership liabilities is $150. X would receive $100 in cash if it sold the interest. X's basis in the partnership interest is $252 ($247 - $145 + $150). The value is $250 ($100 + $150). Net built-in loss is $2. X's basis is reduced to $250. (Treas. Reg. § 1.362-4(h), Example 8(i)(A))
  • TRAP. The liability shift between transferor and transferee can create a loss duplication transaction even when the partnership's assets have not declined in value. Always compute the § 752 liability effect separately.

Step 9B. S Corporation Transferors

• The § 1367(a)(2)(D) expense rule.
  • If an S corporation transfers property in a loss duplication transaction with respect to which a § 362(e)(2)(C) election is made, the resulting reduction to the S corporation's basis in the Acquiring stock is treated as an expense of the S corporation described in § 1367(a)(2)(D). (Treas. Reg. § 1.362-4(e)(2))
  • This reduction flows through to decrease each shareholder's basis in the S corporation stock.
  • If a shareholder's stock basis is reduced to zero, the reduction may affect the shareholder's debt basis under § 1367(b)(2).
• Transfers TO an S corporation.
  • If a person transfers property to an S corporation in a loss duplication transaction and no § 362(e)(2)(C) election is made, the resulting asset basis reduction under § 362(e)(2)(A) is NOT treated as an expense of the S corporation described in § 1367(a)(2)(D). (Treas. Reg. § 1.362-4(f))
  • This is a critical asymmetry. When the S corporation is the Acquiring corporation and the default rule applies, the shareholder's basis in the S corporation stock is preserved at its full exchanged basis. The asset basis reduction does not pass through to shareholders.
  • EXAMPLE. A contributes Asset 1 (basis $90, FMV $60) and Asset 2 (basis $110, FMV $120) to S, an S corporation. No election is made. Net built-in loss is $20. S's basis in Asset 1 is reduced to $70. The $20 reduction to S's asset basis does NOT require A to reduce basis in S stock under § 1367(a)(2)(D). A's basis in S stock remains the full exchanged basis. (Treas. Reg. § 1.362-4(h), Example 9(ii)(A)(3))

Step 9C. § 304 Transactions

• § 362(e)(2) applies to deemed § 351 exchanges in § 304 transactions.
  • Under § 304(a)(1), a sale of stock by a shareholder to a related corporation is recharacterized as (i) a transfer of stock to the acquiring corporation in exchange for stock in a § 351 transaction, followed by (ii) a redemption by the acquiring corporation of the stock deemed issued.
  • The deemed § 351 exchange is subject to § 362(e)(2) if the basis of the acquired stock exceeds its value. (Treas. Reg. § 1.362-4(h), Example 7)
  • EXAMPLE. A owns all the stock of X (basis $90, value $60) and all the stock of Y. A sells all his X stock to Y for $60. Under § 304, A is treated as transferring X stock to Y in a § 351 exchange. Y's basis in the X stock would be $90 (exceeding its $60 value), so the transfer is a loss duplication transaction. Y's basis in the X stock is reduced to $60. A has an exchanged basis of $90 in the Y stock deemed received, and the deemed redemption is analyzed under § 302. (Treas. Reg. § 1.362-4(h), Example 7)

Step 10. Cross-Border Transactions and Related Provisions

• § 367(b) transactions.
  • Transfers of property to foreign corporations in exchanges described in § 351 may be subject to § 367(b), which overrides § 351 nonrecognition in certain circumstances.
  • § 362(e)(2) applies to the extent the transaction is also described in § 362(a) and § 367(b) does not prevent the application of § 351.
  • When a domestic corporation transfers assets to a foreign corporation in a § 351 exchange, the domestic transferor remains subject to U.S. tax, and § 362(e)(2) applies if the transfer triggers a loss duplication transaction.
• Interaction with § 743(b) for partnership interests.
  • If a partnership interest with a § 362(e)(2) basis reduction is held by a partnership that has a § 754 election in effect (or if § 743(b) would otherwise apply), § 1.743-1 rules apply after the § 362 basis adjustment. (Treas. Reg. § 1.362-4(g)(12)(ii))
  • The downward basis adjustment under § 743(b) takes into account the § 362(e)(2) reduction.
• CAUTION. The two-year watch period for foreign transactions.
  • For transactions that qualify for the foreign transaction exception under Treas. Reg. § 1.362-4(c)(2), monitor for triggering events for at least two years after the transaction.
  • Document that the original transaction and any subsequent events were not entered into with a view to avoiding § 362(e)(2). (Treas. Reg. § 1.362-4(c)(2)(iii))
  • If a triggering event occurs within two years, the exception is lost and § 362(e)(2) applies retroactively. The applicable party must file any required § 362(e)(2)(C) Statement in the first taxable year in which the triggering event occurs.

Step 11. State Tax Conformity

• Federal consolidated return states.
  • In states that follow the federal consolidated return filing rules, § 362(e)(2) does not apply to intercompany transactions under § 1.1502-80(h). The transferee corporation takes the full carryover basis in the assets. (Treas. Reg. § 1.1502-80(h)(1))
• Separate-return states.
  • In states that require separate returns for each corporation, § 362(e)(2) applies even to intercompany transfers. ("Desirability, Mechanics of Making Sec. 362(e)(2) Elections for State Tax Returns," The Tax Adviser, July 2015)
  • The default rule reduces the transferee's asset basis to FMV, and the transferor takes stock with carryover basis.
  • A § 362(e)(2)(C) election flips the result, preserving the transferee's asset basis and reducing the transferor's stock basis.
• Strategic state tax planning.
  • In separate-return states with built-in loss property, the default rule may reduce the subsidiary's depreciation deductions, increasing the subsidiary's separate state taxable income.
  • A § 362(e)(2)(C) election preserves the subsidiary's higher asset basis, producing larger state depreciation deductions.
  • The state tax benefit of the election must be weighed against the federal and state consequences of the reduced stock basis.
• Protective elections for state tax purposes.
  • Even when § 362(e)(2) does not apply at the federal level (for example, in a consolidated return intercompany transaction), consider making a protective § 362(e)(2)(C) election to preserve basis for separate-return states. (PLR 201414006 (Jan. 9, 2014))
  • The federal election has no effect on the federal return when § 1.1502-80(h) applies, but may be recognized by states that conform to federal basis rules.
  • CAUTION. Some states may require a separate state-level election even when a federal election is made. Analyze each state's conformity rules.
• State conformity date issues.
  • Rolling conformity states automatically adopt current federal law including § 362(e)(2) and the election.
  • Static conformity states conform to the IRC as of a specific date and may not include § 362(e)(2) if their conformity date predates the 2004 enactment.
  • Hybrid states may conform only to certain enumerated Code sections and may not recognize § 362(e)(2) or the election.

Step 12. Related Anti-Abuse Doctrines

• Step-transaction doctrine.
  • If a series of steps is treated as an integrated transaction under the step-transaction doctrine, the § 362(e)(2) analysis applies to the integrated whole, not to each step separately.
  • The binding commitment test, mutual interdependence test, and end result test may all cause separate contributions to be treated as a single transaction for § 362(e)(2) purposes. (Commissioner v. Gordon, 391 U.S. 83, 96 (1968)) (Penrod v. Commissioner, 88 T.C. 1415, 1429 (1987))
  • TRAP. Prearranged sales of stock received in a § 351 exchange, when combined with a loss property contribution, may be collapsed into an integrated transaction that triggers § 362(e)(2) or breaks the § 351 control test. See generally Intermountain Lumber Co. v. Commissioner, 65 T.C. 1025 (1976) (binding obligation to sell stock received in § 351 exchange broke control under step-transaction).
• Economic substance and business purpose.
  • A transaction that lacks economic substance or business purpose, independent of its tax benefits, may be disregarded or recharacterized.
  • If a contribution of built-in loss property is part of a transaction lacking economic substance, the IRS may challenge the entire transaction, not just the § 362(e)(2) analysis.
  • The economic substance doctrine requires (i) a meaningful change in the taxpayer's economic position (objective economic substance), and (ii) a business purpose for the transaction (subjective business purpose). (26 C.F.R. § 1.7701(o))
  • § 362(e)(2) itself is not elective and does not depend on business purpose. However, a transaction structured solely to shift the location of a built-in loss (for example, contributing loss property to a corporation shortly before selling the stock) may be challenged under the economic substance doctrine.
• Substance over form.
  • If the substance of a transaction differs from its form, the IRS may recharacterize the transaction. A purported capital contribution that is in substance a sale may be treated as a taxable sale, taking the transaction outside § 351 and rendering § 362(e)(2) inapplicable.
  • EXAMPLE. A purported contribution of property to a newly formed corporation in exchange for stock, where the contributor has a binding right to have the corporation immediately sell the property and distribute the proceeds, may be recharacterized as a sale of the property by the contributor followed by a distribution, with § 362(e)(2) never coming into play.

Step 13. Late Election Relief Under § 301.9100

• Relief is available for missed elections.
  • Taxpayers who fail to timely make a § 362(e)(2)(C) election (including failing to enter into the written binding agreement or failing to file the § 362(e)(2)(C) Statement) may seek an extension of time under §§ 301.9100-1 and 301.9100-3. (PLR 202614019 (Apr. 3, 2026)) (PLR 202529003 (July 18, 2025))
  • § 362(e)(2)(C) is a regulatory election. The Commissioner has discretion to grant a reasonable extension of time. (Treas. Reg. § 301.9100-1(c))
• The reasonable and good faith standard.
  • Relief will be granted when the taxpayer provides evidence establishing that the taxpayer acted reasonably and in good faith, and that granting relief will not prejudice the interests of the government. (Treas. Reg. § 301.9100-3(c))
  • A taxpayer is deemed to have acted reasonably and in good faith if (among other grounds) the taxpayer reasonably relied on a qualified tax professional who failed to make or advise the taxpayer to make the election. (Treas. Reg. § 301.9100-3(b)(1)(v))
• Standard conditions imposed by the IRS.
  • The extension is conditioned on the aggregate tax liability of all affected taxpayers not being lower than it would have been if the election had been timely made, taking into account the time value of money. (PLR 202614019) (PLR 201418034 (May 2, 2014))
  • The taxpayer must attach a copy of the private letter ruling to any income tax return to which it is relevant.
  • The ruling is directed only to the requesting taxpayer and may not be cited as precedent under § 6110(k)(3).
• Procedure for seeking relief.
  • File Form 872 or a similar consent extending the period for assessment.
  • Submit a ruling request to the IRS National Office with detailed facts, affidavits from responsible persons, and a representation that the taxpayer is not seeking to alter a return position for which an accuracy-related penalty under § 6662 could be imposed.
  • The request must be filed before the IRS discovers the failure.
  • TRAP. Relief is not automatic. The IRS evaluates each request on its facts and circumstances. Taxpayers should not rely on late relief as a backup plan.

Step 14. Documentation and Reporting

• Required documentation when § 362(e)(2) applies (default rule).
  • Maintain a schedule of all contributed assets showing (i) adjusted basis immediately before contribution, (ii) fair market value immediately after contribution, and (iii) the computation of net built-in loss and allocable basis reduction for each loss duplication property.
  • Retain qualified appraisals or other valuation documentation supporting the fair market value of each contributed asset.
  • Document the transferor-by-transferor analysis if multiple transferors are involved.
  • Preserve all workpapers showing that § 362(e)(1) does not apply to the transaction.
• Required documentation when the § 362(e)(2)(C) election is made.
  • The written, binding agreement between Transferor and Acquiring to elect § 362(e)(2)(C), executed before the election statement is filed. (Treas. Reg. § 1.362-4(d)(1)(i))
  • The § 362(e)(2)(C) Statement, titled exactly as prescribed, with all required content. (Treas. Reg. § 1.362-4(d)(3)(i))
  • Proof of timely filing of the statement on or with the applicable party's original U.S. return. (Treas. Reg. § 1.362-4(d)(3)(ii))
  • Retain copies of both the binding agreement and the filed statement permanently.
• The seven-tier filing hierarchy.
  • Tier A. If Transferor is required to file a U.S. return, Transferor files with its timely filed original return for the year of transfer. (Treas. Reg. § 1.362-4(d)(3)(ii)(A))
  • Tier B. If Tier A does not apply and Transferor is a CFC or CFP, all controlling U.S. shareholders or all reporting U.S. partners file with their timely filed original returns for the year of transfer. (Treas. Reg. § 1.362-4(d)(3)(ii)(B))
  • Tier C. If Tiers A and B do not apply and Acquiring is required to file a U.S. return, Acquiring files with its timely filed original return for the year of transfer. (Treas. Reg. § 1.362-4(d)(3)(ii)(C))
  • Tier D. If Tiers A through C do not apply and Acquiring is a CFC, all of Acquiring's controlling U.S. shareholders file with their timely filed original returns. (Treas. Reg. § 1.362-4(d)(3)(ii)(D))
  • Tier E. If Tiers A through D do not apply and Transferor later becomes a U.S. person, CFC, or CFP, Transferor (or its controlling persons) files in the first taxable year in which the change occurs. (Treas. Reg. § 1.362-4(d)(3)(ii)(E))
  • Tier F. If Tiers A through E do not apply and Acquiring later becomes a U.S. person, CFC, or CFP, Acquiring (or its controlling persons) files in the first taxable year in which the change occurs. (Treas. Reg. § 1.362-4(d)(3)(ii)(F))
  • Tier G. If Tiers A through F do not apply and the basis of loss duplication property or Acquiring stock later becomes relevant for Federal tax purposes, the acquiring person (or its controlling persons) files in the first taxable year in which basis becomes relevant. (Treas. Reg. § 1.362-4(d)(3)(ii)(G))
• Pass-through entity filing.
  • If Transferor is a partnership, S corporation, trust, or other pass-through entity, the ENTITY (not individual partners or shareholders) files the statement, without regard to whether the entity is foreign or domestic. (Treas. Reg. § 1.362-4(d)(3)(ii))
  • Exception. For CFC and CFP transferors, the controlling U.S. shareholders or reporting U.S. partners file.
• No specific form required.
  • The IRS has not issued a specific form for the § 362(e)(2)(C) election. The § 362(e)(2)(C) Statement is a plain-language document prepared by the taxpayer or practitioner. (Treas. Reg. § 1.362-4(d)(3)(i))
  • The Instructions for Form 1120 confirm that "if an election is made, a statement must be filed in accordance with Regulations section 1.362-4(d)(3)." (Instructions for Form 1120)
• Related reporting on Form 8594.
  • If the transaction is an asset acquisition reportable under § 1060, Form 8594 (Asset Acquisition Statement) may be required. The basis determined under § 362(e)(2) or the § 362(e)(2)(C) election affects the asset values reported on Form 8594.
  • CAUTION. The allocation of purchase price on Form 8594 under § 1060 must be consistent with the basis determined under § 362(e)(2). Do not report the pre-reduction carryover basis on Form 8594 if the default rule applied.
• Record retention.
  • Retain all records supporting the § 362(e)(2) analysis for at least the statute of limitations period (generally three years from the filing date of the return for the year of transfer).
  • If the § 362(e)(2)(C) election is made, retain the binding agreement and election statement permanently, as the election is irrevocable and may be relevant for future transactions involving the same stock or assets.